UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-K





þ
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
the fiscal year ended December 31, 2008


or





o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
the transition period from  to .





Commission
File Number 0-49731





SEVERN
BANCORP, INC.




(Exact
name of registrant as specified in its charter)




Maryland
            52-1726127(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification Number)200
      Westgate Circle, Suite 200,  Annapolis, Maryland
            21401(Address
      of principal executive offices)
            (Zip
      Code)





(410)
260-2000


(Registrant’s telephone number,
including area code)





Securities
registered pursuant to Section 12(b) of the Act:


Title
      of each class
            Name
      of each exchange on which registeredCommon
      Stock, par value $.01 per share
            Nasdaq
      Capital Market





Securities
registered pursuant to Section 12(g) of the Act: None








Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.


Yes
o   No
þ





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.


Yes
o   No
þ


Note - Checking the box above
will not relieve any registrant required to file reports pursuant to Section 13
of 15(d) of the Exchange Act from their obligations under those
Sections.








Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90
days.   Yes þ  No o





Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of
this chapter) is not contained herein, and will not be contained, to the best of
registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.         o





Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, a non-accelerated
filer, or a smaller reporting company.  See definition of “accelerated
filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2
of the Exchange Act. (Check one):





Large accelerated
filer   o                                                            Accelerated
filer o                                                           Non-accelerated
filer o


Smaller reporting company þ





Indicate by check mark whether the
registrant is a shell company (as defined in Rule12b-2 of the
Act).  Yes o  Noþ





The
aggregate market value of the voting stock held by non-affiliates of the
registrant, based on the closing sale price of the registrant’s common stock on
June 30, 2008 was $31,634,558 ($6.50 per share based on shares of common stock
outstanding at June 30, 2008).





(APPLICABLE
ONLY TO CORPORATE REGISTRANTS)





Indicate the number of shares
outstanding for each of the registrant’s classes of common stock, as of the
latest practicable date.





As of March 1, 2009, there were issued
and outstanding 10,066,679 shares of the registrant’s common
stock.





DOCUMENTS
INCORPORATED BY REFERENCE





Portion’s of the registrant’s
Definitive Proxy Statement for its 2009 Annual Meeting of Stockholders, which
Definitive Proxy Statement will be filed with the Securities and Exchange
Commission no later than 120 days after the registrant’s fiscal year-ended
December 31, 2008, are incorporated by reference into Part III of this Form
10-K; provided, however, that the Compensation Committee Report, the Audit
Committee Report and any other information in such proxy statement that is not
required to be included in this Annual Report on Form 10-K, shall not be deemed
to be incorporated herein by reference or filed as a part of this Annual Report
on Form 10-K.








Table
of Contents





Section
                        
                        Page
      No.PART
      I
                        
                        1Item
      1
                        Business
                        1Item
      1A
                        Risk
      Factors
                        28Item
      1B
                        Unresolved
      Staff Comments
                        36Item
      2
                        Properties
                        36Item
      3
                        Legal
      Proceedings
                        36Item
      4
                        Submission of Matters to a Vote
      of Security Holders
                        36Item
      4.1
                        Executive
      Officers of the Registrant That Are Not Directors
                        36PART
      II
                        
                        37Item
      5
                        Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                        37Item
      6
                        Selected
      Financial Data
                        40Item
      7
                        Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        44Item
      7A
                        Quantitative
      and Qualitative Disclosures About Market Risk
                        53Item
      8
                        Financial
      Statements and Supplementary Data
                        54Item
      9
                        Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                        54Item
      9A
                        Controls
      and Procedures
                        54Item
      9B
                        Other
      Information
                        56PART III
                        
                        56Item
      10
                        Directors and Executive
      Officers of the Registrant and Corporate Governance
                        56Item
      11
                        Executive
      Compensation
                        56Item
      12
                        Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                        57Item
      13
                        Certain Relationships and
      Related Transactions, and Director Independence
                        57Item
      14
                        Principal
      Accounting Fees and Services
                        57PART
      IV
                        
                        58Item
      15
                        Exhibits,
      Financial Statement Schedules
                        58SIGNATURES
                        
                        60





i


SPECIAL NOTE REGARDING
FORWARD-LOOKING STATEMENTS





Severn Bancorp, Inc. (“Bancorp”) may
from time to time make written or oral “forward-looking statements”, (as defined
in the Securities Exchange Act of 1934, as amended, and the regulations there
under) including statements contained in Bancorp’s filings with the Securities
and Exchange Commission (including this Annual Report on Form 10-K and the
exhibits thereto), in its reports to stockholders and in other communications by
Bancorp, pursuant to the “safe harbor” provisions of the Private Securities
Litigation Reform Act of 1995.





Forward-looking statements include,
but are not limited to:





·
            Statements
      contained in “Item 1A. Risk
Factors;”




·
            Statements
      concerning liquidity and business
plans;




·
            Statements
      concerning allowance for loan losses, liquidity, capital adequacy
      requirements, unrealized losses, guarantees, the Bank being
      well-capitalized, and impact of accounting
  pronouncements;




·
            Competitive
      strengths; and




·
            Statements
      as to trends or Bancorp’s or management’s beliefs, expectations and
      opinions.




The words “anticipate,” “believe,”
“estimate,” “expect,” “intend,” “may,” “plan,” “will,” “would,” “could,”
“should,” “guidance,” “potential,” “continue,” “project,” “forecast,”
“confident,” and similar expressions are typically used to identify
forward-looking statements.  These statements are based on assumptions
and assessments made by management in light of their experience and their
perception of historical trends, current conditions, expected future
developments and other factors they believe to be appropriate.  Any
forward-looking statements are not guarantees of Bancorp’s future performance
and are subject to risks and uncertainties and may be affected by various
factors that may cause actual results, developments and business decisions to
differ materially from those in the forward-looking statements.  Some
of the factors that may cause actual results, developments and business
decisions to differ materially from those contemplated by such forward-looking
statements include the risk factors discussed under “Item 1A. Risk Factors” and
the following:





·
            Changes
      in general economic and political conditions and by governmental monetary
      and fiscal policies;




·
            Changes
      in the economic conditions of the geographic areas in which Bancorp
      conducts business;




·
            Changes
      in interest rates;




·
            A
      downturn in the real estate markets in which Bancorp conducts
      business;




·
            Environmental
      liabilities with respect to properties Bancorp has
  title;




·
            Changes
      in federal and state regulation;




·
            Bancorp’s
      ability to estimate loan losses;




·
            Competition;




·
            Breaches
      in security or interruptions in Bancorp’s information
    systems;




·
            Bancorp’s
      ability to timely develop and implement
  technology;




·
            Bancorp’s
      ability to retain its management
team;




·
            Bancorp’s
      ability to maintain effective internal controls over financial reporting
      and disclosure controls and procedures;
and




·
            Terrorist
      attacks and threats or actual war.







ii








Bancorp can
give no assurance that any of the events anticipated by the forward-looking
statements will occur or, if any of them does, what impact they will have on
Bancorp’s results of operations and financial condition.  Bancorp
disclaims any intent or obligation to publicly update or revise any
forward-looking statements, regardless of whether new information becomes
available, future developments occur or otherwise.























iii







PART I





Item
1.  Business





General





Bancorp is a savings and loan holding
company chartered as a corporation in the state of Maryland in
1990.  It conducts business through three
subsidiaries:  Severn Savings Bank, FSB (“Bank”), its principal
subsidiary; Louis Hyatt, Inc. (“Hyatt Commercial”), which is doing business as
Hyatt Commercial, a commercial real estate brokerage and property management
company; and SBI Mortgage Company (“SBI”), which holds mortgages that do not
meet the underwriting criteria of the Bank, and is the parent company of
Crownsville Development Corporation (“Crownsville”), which is doing business as
Annapolis Equity Group, which acquires real estate for syndication and
investment purposes.





On December 17, 2004, Bancorp
acquired all the common stock of newly formed Severn Capital Trust I, a Delaware
business trust.  Severn Capital Trust I issued $20,000,000 of trust
preferred securities in a private placement pursuant to an applicable exemption
from registration under the Securities Act of 1933, as
amended.  Bancorp irrevocably and unconditionally guaranteed the trust
preferred securities.  The proceeds of the trust preferred securities
were used to purchase Bancorp’s Junior Subordinated Debt Securities due 2035
(the “2035 Debentures”).





On November 15, 2008, Bancorp sold a
total of 70 units, at an offering price of $100,000 per unit, for gross proceeds
of $7.0 million pursuant in a private placement exempt from registration under
the Securities Act of 1933.    Each unit consisted of 6,250
shares of Bancorp's Series A 8.0% Non-Cumulative Convertible Preferred Stock
("Series A Preferred Stock") and Bancorp's Subordinated Notes in the original
principal amount of $50,000 ("Subordinated Notes").  In the private
placement, Bancorp issued a total of 437,500 shares of its Series A Preferred
Stock and $3.5 million aggregate principal amount of its Subordinated
Notes.





The recently enacted Emergency
Economic Stabilization Act of 2008 (“EESA”) authorizes the U.S. Department of
the Treasury (“Treasury Department”) to purchase from financial institutions and
their holding companies up to $700 billion in mortgage loans, mortgage-related
securities and certain other financial instruments, including debt and equity
securities issued by financial institutions and their holding companies in the
Troubled Asset Relief Program (”TARP”).  The purpose of TARP is to
restore confidence and stability to the U.S. banking system and to encourage
financial institutions to increase their lending to customers and to each
other.  The Treasury Department has allocated $250 billion towards the
TARP Capital Purchase Program (“CPP”).  Under the CPP, Treasury will
purchase debt or equity securities from participating
institutions.  The TARP also will include direct purchases or
guarantees of troubled assets of financial institutions.  The Company
made application to the Treasury Department to participate in this
program.  On November 21, 2008 Bancorp entered into a Letter Agreement
(the “Purchase Agreement”) with the Treasury Department, pursuant to which
Bancorp issued and sold (i) 23,393 shares of its Fixed Rate Cumulative Perpetual
Preferred Stock, Series B, par value $0.01 per share and liquidation preference
$1,000 per share, (the “Series B Preferred Stock”) and (ii) a warrant (the
“Warrant”) to purchase 556,976 shares of Bancorp’s common stock at $6.30 per
(the “Common Stock”), for an aggregate purchase price of $ 23,393,000 in
cash.  Closing of the sale occurred on November 21, 2008.





The Bank has four branches in Anne
Arundel County, Maryland, which offer a full range of deposit products, and
originate mortgages in its primary market of Anne Arundel County, Maryland and,
to a lesser extent, in other parts of Maryland, Delaware and
Virginia.





As of December 31, 2008, Bancorp had
total assets of $987,651,000, total deposits of $683,866,000, and total
stockholders’ equity of $123,667,000. Net income of Bancorp for the year ended
December 31, 2008 was $4,113,000.  For more information, see “Item 6.
Selected Financial Data.”









1





Bancorp’s
internet address is www.severnbank.com.  Bancorp makes available free
of charge on www.severnbank.com its annual report on Form 10-K, quarterly
reports on Form 10-Q and current reports on Form 8-K, and amendments to those
reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange
Act, as soon as reasonably practicable after it electronically files such
material with, or furnishes it to, the SEC.





In addition, we will provide, at no
cost, paper or electronic copies of our reports and other filings made with the
SEC.  Requests should be directed to:





Thomas G.
Bevivino


Executive
Vice President


Severn
Bancorp, Inc.


200
Westgate Circle, Suite 200


Annapolis,
Maryland 21401





The information on the website listed
above, is not and should not be considered part of this Annual Report on Form
10-K and is not incorporated by reference in this document.  This
website is and is only intended to be an inactive textual
reference.


























2





Business of the
Bank







The Bank was organized in 1946 in
Baltimore, Maryland as Pompei Permanent Building and Loan
Association.  It relocated to Annapolis, Maryland in 1980 and its name
was changed to Severn Savings Association.  Subsequently, the Bank
obtained a federal charter and changed its name to Severn Savings Bank,
FSB.  The Bank operates four full-service branch offices, and one
administrative office.  The Bank operates as a federally chartered
savings bank whose principal business is attracting deposits from the general
public and investing those funds in mortgage and commercial
loans.   The Bank also uses advances, or loans, from the Federal
Home Loan Bank of Atlanta, (“FHLB-Atlanta”) to fund its mortgage
activities.  The Bank provides a wide range of retail and mortgage
banking services. Deposit services include checking, savings, money market, time
deposit and individual retirement accounts. Loan services include various types
of real estate, consumer, and commercial lending. The Bank also provides safe
deposit boxes, ATMs, debit cards, and internet and telephone
banking.





The Bank’s revenues are derived
principally from interest earned on mortgage, commercial and other loans, and
fees charged in connection with the loans and banking services.  The
Bank’s primary sources of funds are deposits, advances from the FHLB-Atlanta,
principal amortization, prepayment of its loans and, in 2008, private placements
of its securities.  The principal executive offices of the Bank are
maintained at 200 Westgate Circle, Suite 200, Annapolis Maryland,
21401.  Its telephone number is 410-260-2000 and its e-mail address is
mailman@severnbank.com.








The Thrift
Industry





Thrift institutions are financial
intermediaries which historically have accepted savings deposits from the
general public and, to a lesser extent, borrowed funds from outside sources and
invested those deposits and funds primarily in loans secured by first mortgage
liens on residential and other types of real estate.  Such
institutions may also invest their funds in various types of short- and
long-term securities.  The deposits of bank and thrift institutions
are insured by the Deposit Insurance Fund (“DIF”) as administered by the Federal
Deposit Insurance Corporation (“FDIC”), and these institutions are subject to
extensive regulations.  These regula­tions govern, among other
things, the lending and other investment powers of thrift institutions,
including the terms of mortgage instruments these institutions are permitted to
utilize, the types of deposits they are permitted to accept, and reserve
require­ments.





The operations of thrift
institutions, including those of the Bank, are significantly affected by general
economic conditions and by related monetary and fiscal policies of the federal
government and regulations and policies of financial institution regulatory
authorities, including the Board of Governors of the Federal Reserve System (the
“FRB”) and the Office of Thrift Supervision (“OTS”).  Lending
activities are influenced by a number of factors including the demand for
housing, conditions in the construction industry, and availability of
funds.  Sources of funds for lending activities include savings
deposits, loan principal payments, proceeds from sales of loans, borrowings from
the FHLB-Atlanta and other sources.  Savings flows at thrift
institutions such as the Bank are influenced by a number of factors including
interest rates on competing investments and levels of personal
income.







3






Earnings





The Bank’s earnings depend primarily
on the difference between income from interest-earning assets such as loans and
investments, and interest paid on interest-bearing liabilities such as deposits
and borrowings.  The Bank typically engages in long-term mortgage
lending at fixed rates of interest, generally for periods of up to 30 years,
while accepting deposits for consider­ably shorter
periods.  However, many of the Bank’s long-term fixed-rate loans are
sold in the secondary market, typically resulting in gains on the sale of such
loans by the Bank.





Generally, rapidly rising interest
rates cause the cost of interest-bearing liabilities to increase more rapidly
than yields on interest-earning assets, thereby adversely affecting the earnings
of many thrift institutions.  While the industry has received expanded
lending and borrowing powers in recent years permitting different types of
investments and mortgage loans, including those with floating or adjustable
rates and those with shorter terms, earnings and operations are still highly
influenced by levels of interest rates and financial market conditions and by
substantial investments in long-term mortgage loans.





Competition





The Annapolis, Maryland area has a
high density of financial institutions, many of which are significantly larger
and have greater financial resources than the Bank, and all of which are
competitors of the Bank to varying degrees.  The Bank’s competition
for loans comes primarily from savings and loan associations, savings banks,
mortgage banking companies, insurance companies, and commercial
banks.  Many of the Bank’s competitors have higher legal lending
limits than the Bank.  The Bank’s most direct competition for deposits
has historically come from savings and loan associations, savings banks,
commercial banks, and credit unions.  The Bank faces additional
competition for deposits from short-term money market funds and other corporate
and government securities funds.  The Bank also faces increased
competition for deposits from other financial institutions such as brokerage
firms, insurance companies and mutual funds.  The Bank is a
community-oriented financial institution serving its market area with a wide
selection of mortgage loans.  Management considers the Bank’s
reputation for financial strength and customer service as its major competitive
advantage in attracting and retaining customers in its market
area.  The Bank also believes it benefits from its community
orientation.





Net Interest
Income





Net interest income increases during
periods when the spread between Bancorp’s weighted average rate at which new
loans are originated and the weighted average cost of interest-bearing
liabilities widens.  Market factors such as interest rates,
competition, consumer preferences, the supply of and demand for housing, and the
availability of funds affect the Bank’s ability to originate loans.





Bancorp has supplemented its interest
income through purchases of investments when appropriate.  This
activity is intended to generate positive interest rate spreads on large
principal balances with minimal administrative expense.





Interest Rate and Volume of
Interest-Related Assets and Liabilities





Both changes in rate and changes in
the composition of Bancorp’s interest-earning assets and interest-bearing
liabilities can have a significant effect on net interest income.





For information concerning the extent
to which changes in interest rates and changes in volume of interest-related
assets and liabilities have affected Bancorp’s interest income and expense
during the fiscal years ended December 31, 2008 and 2007, refer to Item 6,
“Selected Financial Data - Rate Volume Table”.










4








Market
Area





The Bank’s market area is primarily
Anne Arundel County, Maryland and nearby areas, due to its four branch
locations, all located in Anne Arundel County.





The Bank has traditionally focused
its lending activities on first mortgage loans secured by real estate for the
purpose of purchasing, refinancing, developing and constructing one-to-four
family residences and commercial properties in and near Anne Arundel County,
Maryland. Beginning in 2008, the Bank has expanded its relationship banking by
offering a full line of products and services necessary for businesses to
succeed.  The Bank does originate mortgage loans throughout the states
of Maryland, Virginia and Delaware.  The Bank participates in the
secondary market and sold approximately 26% of the fixed-rate long-term
mortgages that it originated in 2008.






5





Loan Portfolio
Composition





The
following table sets forth the composition of Bancorp’s loan portfolios by type
of loan at the dates indicated.  The table includes a reconciliation
of total net
loans receivable, including loans held for sale, after consideration of
undisbursed portion of loans, deferred loan fees and discounts, and allowances
for losses on loans as of December 31:




2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Amount
                
                
                Percent
                
                
                Amount
                
                
                Percent
                
                
                Amount
                
                
                Percent
                
                
                Amount
                
                
                Percent
                
                
                Amount
                
                
                Percent(dollars
      in thousands)Residential
      mortgage
                
                $
                355,909
                
                
                
                36.55
                %
                
                $
                320,303
                
                
                
                32.45
                %
                
                $
                249,448
                
                
                
                26.15
                %
                
                $
                219,988
                
                
                
                23.71
                %
                
                $
                215,767
                
                
                
                27.30
                %Construction,
      land acquisition anddevelopment
                
                
                242,359
                
                
                
                24.89
                %
                
                
                297,823
                
                
                
                30.18
                %
                
                
                339,122
                
                
                
                35.55
                %
                
                
                390,376
                
                
                
                42.07
                %
                
                
                343,101
                
                
                
                43.42
                %Land
                
                
                82,642
                
                
                
                8.49
                %
                
                
                93,717
                
                
                
                9.50
                %
                
                
                90,747
                
                
                
                9.51
                %
                
                
                77,319
                
                
                
                8.33
                %
                
                
                33,419
                
                
                
                4.23
                %Lines
      of credit
                
                
                34,872
                
                
                
                3.58
                %
                
                
                29,713
                
                
                
                3.01
                %
                
                
                40,733
                
                
                
                4.27
                %
                
                
                35,491
                
                
                
                3.82
                %
                
                
                29,096
                
                
                
                3.68
                %Commercial
      real estate
                
                
                214,209
                
                
                
                22.00
                %
                
                
                205,755
                
                
                
                20.85
                %
                
                
                193,299
                
                
                
                20.26
                %
                
                
                163,449
                
                
                
                17.61
                %
                
                
                127,768
                
                
                
                16.17
                %Commercial
      non-real estate
                
                
                3,084
                
                
                
                0.32
                %
                
                
                3,416
                
                
                
                0.34
                %
                
                
                3,348
                
                
                
                0.35
                %
                
                
                3,412
                
                
                
                0.37
                %
                
                
                3,859
                
                
                
                0.49
                %Home
      equity
                
                
                39,040
                
                
                
                4.01
                %
                
                
                32,748
                
                
                
                3.32
                %
                
                
                32,758
                
                
                
                3.44
                %
                
                
                32,974
                
                
                
                3.55
                %
                
                
                28,101
                
                
                
                3.56
                %Consumer
                
                
                1,083
                
                
                
                0.11
                %
                
                
                2,355
                
                
                
                0.24
                %
                
                
                1,537
                
                
                
                0.16
                %
                
                
                1,768
                
                
                
                0.19
                %
                
                
                2,489
                
                
                
                0.31
                %Loans
      held for sale
                
                
                453
                
                
                
                0.05
                %
                
                
                1,101
                
                
                
                0.11
                %
                
                
                2,970
                
                
                
                0.31
                %
                
                
                3,216
                
                
                
                0.35
                %
                
                
                6,654
                
                
                
                0.84
                %Total
      gross loans
                
                
                973,651
                
                
                
                100.00
                %
                
                
                986,931
                
                
                
                100.00
                %
                
                
                953,962
                
                
                
                100.00
                %
                
                
                927,993
                
                
                
                100.00
                %
                
                
                790,254
                
                
                
                100.00
                %Deferred
      loan origination fees
                  and
      costs, net
                
                
                (4,439
                )
                
                
                
                
                
                
                (4,898
                )
                
                
                
                
                
                
                (4,712
                )
                
                
                
                
                
                
                (4,916
                )
                
                
                
                
                
                
                (4,157
                )Loans
      in process
                
                
                (57,940
                )
                
                
                
                
                
                
                (78,238
                )
                
                
                
                
                
                
                (104,747
                )
                
                
                
                
                
                
                (136,239
                )
                
                
                
                
                
                
                (123,195
                )Allowance
      for loan losses
                
                
                (14,813
                )
                
                
                
                
                
                
                (10,781
                )
                
                
                
                
                
                
                (9,026
                )
                
                
                
                
                
                
                (7,505
                )
                
                
                
                
                
                
                (5,935
                )Total
      loans net
                
                $
                896,459
                
                
                
                
                
                
                $
                893,014
                
                
                
                
                
                
                $
                835,477
                
                
                
                
                
                
                $
                779,333
                
                
                
                
                
                
                $
                656,967








6


Lending
Activities





General





The Bank originates mortgage loans of
all types, including residential, residential-construction,
commercial-construction, commercial, land and residential lot
loans.  To a lesser extent, the Bank also originates non-mortgage
loans, which include consumer, business and commercial loans.  These
loans constitute a small part of the Bank’s portfolio.





The Bank originated and funded
$177,714,000 and $251,681,000 of mortgage loans for the years ended December 31,
2008 and 2007, respectively.





Loan Origination
Procedures





The following table contains
information on the activity of the Bank’s loans held for sale and its loans held
for investment in its portfolio:




For
      the Years ended December 31,2008
                      
                      
                      2007
                      
                      
                      2006(dollars
      in thousands)Held
      for Sale:Beginning
      balance
                      
                      $
                      1,101
                      
                      
                      $
                      2,970
                      
                      
                      $
                      3,216Originations
                      
                      
                      13,145
                      
                      
                      
                      18,320
                      
                      
                      
                      31,322Net
      sales
                      
                      
                      (13,793
                      )
                      
                      
                      (20,189
                      )
                      
                      
                      (31,568
                      )Ending
      balance
                      
                      $
                      453
                      
                      
                      $
                      1,101
                      
                      
                      $
                      2,970Held
      for investment:Beginning
      balance
                      
                      $
                      985,830
                      
                      
                      $
                      950,992
                      
                      
                      $
                      924,777Originations
      and purchases
                      
                      
                      210,984
                      
                      
                      
                      239,336
                      
                      
                      
                      260,715Repayments/payoffs
                      
                      
                      (223,616
                      )
                      
                      
                      (204,498
                      )
                      
                      
                      (234,500
                      )Ending
      balance
                      
                      $
                      973,198
                      
                      
                      $
                      985,830
                      
                      
                      $
                      950,992





The Bank originates residential
mortgage loans that are to be held in the Bank’s loan portfolio as well as loans
that are intended for sale in the secondary market.  Loans sold in the
secondary market are primarily sold to investors with which the Bank maintains a
correspondent relationship.  These loans are made in conformity with
standard underwriting criteria to assure maximum eligibility for possible resale
in the secondary market, and are approved either by the Bank’s underwriter or
the correspondent’s underwriter.  Loans considered for the Bank’s
portfolio are approved by the Bank’s loan committee.  Meetings of the
loan committee are open to attendance by any member of the Bank’s Board of
Directors who wishes to attend.  The loan committee reports to and
consults with the Board of Directors in interpreting and applying the Bank’s
lending policy.  Single loans greater than $2,000,000, or loans to one
borrower aggregating more than $4,000,000, up to $19,934,000 (the maximum amount
of a loan to one borrower as of December 31, 2008), must also have Board of
Directors’ approval.




7






Loans that are sold are typically
long-term (15 or more years) loans with fixed interest rates eligible for resale
in the secondary market.  Loans retained for Bancorp’s portfolio
typically include construction loans, commercial loans and loans that
periodically reprice or mature prior to the end of an amortized
term.  Loans are generally sold with servicing
released.  However, as of December 31, 2008, the Bank was servicing
$501,000 in loans for Federal Home Loan Mortgage Corporation (“FHLMC”) and
$77,116,000 in loans for other investors.





The following table contains
information, as of December 31, 2008, on the percentage of fixed-rate
single-family loans serviced for others by the Bank, by interest rate
category.





Interest
      rate range
                                
                                Percentage
      of PortfolioLess
      than 5.00%
                                
                                59.2%5.01
      – 6.00%
                                
                                0.0%6.01
      – 7.00%
                                
                                19.4%7.01
      – 8.00%
                                
                                18.5%Over
      8.00%
                                
                                2.9%100.0%





The Bank’s mortgage loan approval
process is intended to assess the borrower’s ability to repay the loan, the
viability of the loan, and the adequacy of the value of the property that will
secure the loan.  The authority of the loan committee to approve loans
is established by the Board of Directors and currently is commensurate with the
Bank’s limitation on loans to one borrower.  The Bank’s maximum amount
of loans to one borrower currently is equal to 15% of the Bank’s unimpaired
capital, or $19,934,000 as of December 31, 2008.  Loans greater than
this amount require participation by one or more additional
lenders.  Letters of credit are subject to the same limitations as
direct loans.  The Bank utilizes independent qualified appraisers
approved by the Board of Directors to appraise the properties securing its loans
and requires title insurance or title opinions so as to insure that the Bank has
a valid lien on the mortgaged real estate.  The Bank requires
borrowers to maintain fire and casualty insurance on its secured
properties.





The procedure for approval of
construction loans is the same for residential mortgage loans, except that the
appraiser evaluates the building plans, construction specifications, and
estimates of construction costs.  The Bank also evaluates the
feasibility of the proposed construction project and the experience and track
record of the developer.  In addition, all construction loans
generally require a commitment from a third-party lender or from the Bank for a
permanent long-term loan to replace the construction loan upon completion of
construction.





Commercial Real Estate
Loans





At December 31, 2008, Bancorp’s
commercial real estate loan portfolio totaled $214,209,000, or 22.0% of
Bancorp’s loan portfolio.  All of Bancorp’s commercial loans are
secured by improved property such as office buildings, retail strip shopping
centers, industrial condominium units and other small businesses most of which
are located in the Bank’s primary lending area.  The largest
commercial real estate loan outstanding at December 31, 2008 was a $7,158,000
loan secured by an office building in Annapolis, Maryland.  This loan
has consistently performed in accordance with the terms of the debt
instrument.





Loans secured by commercial real
estate properties generally involve a greater degree of risk than residential
mortgage loans.  Because payments on loans secured by commercial real
estate properties are often dependent on the successful operation or management
of the properties, repayment of these loans may be subject to a greater extent
to adverse conditions in the real estate market or the economy.




8






Construction
Loans





The Bank originates loans to finance
the construction of one-to-four family dwellings, and to a lesser extent,
commercial real estate.  It also originates loans for the acquisition
and development of  unimproved property to be used for residential and/or
commercial purposes in cases where the Bank is to provide the construction funds
to improve the properties.  As of December 31, 2008, Bancorp had 346
construction loans outstanding in the gross aggregate amount of $242,359,000,
representing 24.9% of its loan portfolio, of which $57,940,000 was
unadvanced.





Construction loan amounts are based
on the appraised value of the property and, for builder loans, a feasibility
study as to the potential marketability and profitability of the
project.  Construction loans generally have terms of up to one year,
with reasonable extensions as needed, and typically have interest rates that
float monthly at margins ranging from the prime rate to 1 percent above the
prime rate.   In addition to builders’ projects, the Bank
finances the construction of single family, owner-occupied houses where
qualified contractors are involved and on the basis of strict written
underwriting and construction loan guidelines.  Construction loans are
structured either to be converted to permanent loans with the Bank upon the
expiration of the construction phase or to be paid off by financing from another
financial institution.





Construction loans afford the Bank
the opportunity to increase the interest rate sensitivity of its loan portfolio
and to receive yields higher than those obtainable on loans secured by existing
residential properties.  These higher yields correspond to the higher
risks associated with construction lending.   Construction loans
involve additional risks attributable to the fact that loan funds are advanced
upon the security of the project under construction that is of uncertain value
prior to its completion.  Because of the uncertainties inherent in
estimating construction costs as well as the market value of the completed
project and the effects of governmental regulation of real property, it is
relatively difficult to value accurately the total funds required to complete a
project and the related loan-to-value ratio.  As a result,
construction lending often involves the disbursement of substantial funds with
repayment dependent, in part, on the ultimate success of the project rather than
the ability of the borrower or guarantor to repay principal and
interest.  If the Bank is forced to foreclose on a project prior to or
at completion, due to a default, there can be no assurance that the Bank will be
able to recover all of the unpaid balance of the loan as well as related
foreclosure and holding costs.  In addition, the Bank may be required
to fund additional amounts to complete the project and may have to hold the
property for an unspecified period of time.  The Bank has attempted to
address these risks through its underwriting procedures and its limited amount
of construction lending on multi-family and commercial real estate
properties.





It is the policy of the Bank to
conduct physical inspections of each property secured by a construction or
rehabilitation loan for the purpose of reporting upon the progress of the
construction of improvements.  These inspections, referred to as
“construction draw inspections,” are to be performed at the time of a request
for an advance of construction funds.  If no construction advance has
been requested, a fee inspector or senior officer of the institution makes an
inspection of the subject property at least quarterly.





Multi-Family
Lending





The Bank occasionally originates
multi-family loans with terms up to 30 years, but with rate adjustments or
balloon payments generally at three to five years.  These loans are
generally made in amounts up to 75% of the appraised value of the secured
property.  In making these loans, the Bank bases its underwriting
decision primarily on the net operating income generated by the real estate to
support the debt service, the financial resources and income level of the
borrower, the borrower’s experience in owning or managing similar property, the
marketability of the property and the Bank’s lending experience with the
borrower.  The Bank also typically receives a personal guarantee from
the borrower.  As of December 31, 2008, $11,143,000, or 1.1% of
Bancorp’s total loan portfolio, consisted of multi-family residential
loans.






9





Land and Residential
Building Lots





Land loans include loans to
developers for the development of residential subdivisions and loans on
unimproved lots primarily to individuals.  At December 31, 2008,
Bancorp had outstanding land and residential building lot loans totaling
$87,246,000, or 9.0% of the total loan portfolio.  The largest of
these loans for $4,612,000, is secured by seven parcels in Severn, Maryland, and
has performed in accordance with the terms of the debt
instrument.  Land development loans typically are short-term loans;
the duration of these loans is typically not greater than three
years.  The interest rate on land loans is generally at least 1% or 2%
over the prime rate.   The loan-to-value ratio generally does not
exceed 75%. Land and residential building lot loans typically are made to
customers of the Bank and developers and contractors with whom the Bank has had
previous lending experience.  In addition to the customary
requirements for these types of loans, the Bank may also require a satisfactory
Phase I environmental study and feasibility study to determine the profit
potential of the development.





Consumer and Other
Loans





The Bank also offers other loans,
primarily business and commercial loans.  These are loans to
businesses that are not secured by real estate although equipment, securities,
or other collateral may secure them.  They constitute a relatively
small part of the Bank’s business, and typically are offered to customers with
long-standing relationships with the Bank.  At December 31, 2008,
$7,835,000, or 0.8%, of the loan portfolio consisted of business and commercial
loans.  In addition, $1,083,000, or 0.1% of the loan portfolio was in
consumer loans.





Loan Portfolio Cash
Flows





The following table sets forth the
estimated maturity of Bancorp’s loan portfolios by type of loan at December 31,
2008.  The estimated maturity reflects contractual terms at December
31, 2008.  Contractual principal repayments of loans do not
necessarily reflect the actual term of the Bank’s loan
portfolios.  The average life of mortgage loans is substantially less
than their contractual terms because of loan prepayments and because of
enforcement of "due on sale" clauses.  The average life of mortgage
loans tends to increase, however, when current mortgage loan rates substantially
exceed rates on existing mortgage loans.





Due
                      
                      
                      Due
      afterWithin
      one
                      
                      
                      1
      through
                      
                      
                      Due
      afteryear
      or less
                      
                      
                      5
      years
                      
                      
                      5
      years
                      
                      
                      Total(dollars
      in thousands)One
      to four family residential
                      
                      $
                      42,063
                      
                      
                      $
                      53,471
                      
                      
                      $
                      317,851
                      
                      
                      $
                      413,385Multifamily
                      
                      
                      1,450
                      
                      
                      
                      2,180
                      
                      
                      
                      7,513
                      
                      
                      
                      11,143Commercial
      and industrial real estate
                      
                      
                      19,181
                      
                      
                      
                      72,667
                      
                      
                      
                      118,752
                      
                      
                      
                      210,600Construction
      and land acquisitionand
      development loans
                      
                      
                      192,864
                      
                      
                      
                      49,495
                      
                      
                      
                      -
                      
                      
                      
                      242,359Land
                      
                      
                      46,140
                      
                      
                      
                      31,795
                      
                      
                      
                      9,311
                      
                      
                      
                      87,246Commercial,
      non-real estate
                      
                      
                      4,088
                      
                      
                      
                      1,538
                      
                      
                      
                      2,209
                      
                      
                      
                      7,835Consumer
                      
                      
                      180
                      
                      
                      
                      730
                      
                      
                      
                      173
                      
                      
                      
                      1,083Total
                      
                      $
                      305,966
                      
                      
                      $
                      211,876
                      
                      
                      $
                      455,809
                      
                      
                      $
                      973,651














10





The following table contains certain
information as of December 31, 2008 relating to the loan portfolio of Bancorp
with the dollar amounts of loans due after one year that have fixed and floating
rates.  All loans are shown maturing based upon contractual maturities
and include scheduled payments but not possible prepayments.





Fixed
                  
                  
                  Floating
                  
                  
                  Total(dollars
      in thousands)One
      to four family residential
                  
                  $
                  195,217
                  
                  
                  $
                  176,105
                  
                  
                  $
                  371,322Multifamily
                  
                  
                  1,634
                  
                  
                  
                  8,059
                  
                  
                  
                  9,693Commercial
      and industrial real estate
                  
                  
                  87,218
                  
                  
                  
                  104,201
                  
                  
                  
                  191,419Construction
      and land acquisitionand
      development loans
                  
                  
                  24,445
                  
                  
                  
                  25,050
                  
                  
                  
                  49,495Land
                  
                  
                  25,309
                  
                  
                  
                  15,797
                  
                  
                  
                  41,106Commercial,
      non-real estate
                  
                  
                  1,833
                  
                  
                  
                  1,914
                  
                  
                  
                  3,747Consumer
                  
                  
                  866
                  
                  
                  
                  37
                  
                  
                  
                  903Total
                  
                  $
                  336,522
                  
                  
                  $
                  331,163
                  
                  
                  $
                  667,685





Loans to One
Borrower





Under regulatory guidelines, the
aggregate amount of loans that the Bank may make to one borrower is 15% of the
Bank’s unimpaired capital and unimpaired surplus, which was $19,934,000 at
December 31, 2008.  The Bank’s three largest loans at December 31,
2008 were a $7,158,000 loan secured by commercial property located in Annapolis,
Maryland, a $7,000,000 line of credit secured by assignments of notes, Deeds of
Trust, pledged stock and certificates of deposit, and a $6,818,000 loan secured
by commercial property located in California, Maryland.





Origination and Purchase and
Sale of Loans





The Bank originates residential loans
in conformity with standard underwriting criteria to assure maximum eligibility
for possible resale in the secondary market.  Although the Bank has
authority to lend anywhere in the United States, it has confined its loan
origination activities primarily to the states of Maryland, Virginia and
Delaware.





Loan originations are developed from
a number of sources, primarily from referrals from real estate brokers,
builders, and existing and walk-in customers.  The Bank also utilizes
the services of loan brokers in its market area.  Loan brokers are
paid on a commission basis (generally 1% of the loan amount) for loans brokered
to the Bank.





The Bank’s mortgage loan approval
process is intended to assess the borrower's ability to repay the loan, the
viability of the loan, and the adequacy of the value of the property that will
secure the loan.  The loan committee of the Bank can approve single
residential and commercial loans up to $2,000,000, and loans that aggregate up
to $4,000,000 to one borrower.  Single loans greater than $2,000,000,
or loans to one borrower aggregating more than $4,000,000, up to $19,934,000
(the maximum amount of a loan to one borrower as of December 31, 2008), must
also have Board of Directors’ approval. The Bank utilizes independent qualified
appraisers approved by the Board of Directors to appraise the properties
securing its loans and requires title insurance or title opinions so as to
insure that the Bank has a valid lien on the mortgaged real estate. The Bank
requires borrowers to maintain fire and casualty insurance on its secured
properties.





The procedure for approval of
construction loans is the same as for residential mortgage loans, except that
the appraiser evaluates the building plans, construction specifications, and
estimates of construction costs.  The Bank also evaluates the
feasibility of the proposed construction project and the experience and track
record of the developer.  In addition, all construction loans
generally require a commitment from a third-party lender or from the Bank for a
permanent long-term loan to replace the construction loan upon completion of
construction.








11





Consumer loans are underwritten on
the basis of the borrower's credit history and an analysis of the borrower's
income and expenses, ability to repay the loan, and the value of the collateral,
if any.





Currently, it is the Bank’s policy to
originate both fixed-rate and adjustable-rate loans. The Bank is currently
active in the secondary market and sells a portion of its fixed-rate
loans.





Interest Rates, Points and
Fees





The Bank realizes interest, point,
and fee income from its lending activities.  The Bank also realizes
income from commitment fees for making commitments to originate loans, and from
prepayment and late charges, loan fees, application fees, and fees for other
miscellaneous services.





The Bank accounts for loan
origination fees in accordance with the Statement of Financial Accounting
Standards (“SFAS”) on Accounting for Nonrefundable Fees and Costs Associated
with Originating or Acquiring Loans ("SFAS No. 91") issued by the Financial
Accounting Standards Board (the "FASB"). SFAS No. 91 prohibits the
immediate recognition of loan origination fees as revenues and requires that
such income (net of certain direct loan origination costs) for each loan be
amortized, generally by the interest method, over the estimated life of the loan
as an adjustment of yield.  The Bank also realizes income from gains
on sales of loans, and servicing released fees for loans sold with servicing
released.





Delinquency and Classified
Assets





Delinquencies





The Board of Directors reviews
delinquencies on all loans monthly.  The Bancorp’s collection
procedures include sending a past due notice to the borrower on the 17th day of
nonpayment, making telephone contact with the borrower between 20 and 30 days
after nonpayment, and sending a letter after the 30th day of nonpayment. A
notice of intent to foreclose is sent between 60 and 90 days after
delinquency.  When the borrower is contacted, the Bancorp attempts to
obtain full payment of the past due amount.  However, Bancorp
generally will seek to reach agreement with the borrower on a payment plan to
avoid foreclosure.  In calculating Bancorp’s allowance for loan
losses, management stratifies its loan portfolio into three distinct
groups.





The first group is made up of
impaired loans as determined using SFAS 114.  Loans are classified as
impaired if they meet either of the following two criteria:





·
            Loans
      that are 90 days or more in arrears (non-accrual loans);
  or


·
            Loans
      that are deemed impaired when, based on current information and events, it
      is probable that a borrower will be unable to collect all amounts due
      according to the contractual terms of the loan agreement (as per SFAS
      114).





Impaired loans are individually
analyzed to determine if a specific reserve is required. Management uses the
current appraisals of the underlying collateral to determine if a specific
reserve is necessary to reduce the loan’s carrying value down to the current
fair market value of the underlying collateral.  In addition,
management, as appropriate, measures impairment based on the present value of
expected future cash flows of the loan for loans that are not solely collateral
dependent.





The second group contains any loans
that management deems “problem loans” that are not included in the impaired loan
group.  These loans have a general reserve placed on them based on
several factors, including the inherent risk of the loan, current market
conditions, the risk rating assigned to the loan and the historical performance
of similar loans.







12






Management
considers all loans with an internal risk rating of 6 or higher that are not
included in impaired loans as problem loans. The general reserves in this group
range from 2% to 8% primarily due to management’s assessment of historical
performance of similar loans and to current market conditions.





The third group is made up of all
remaining loans, which are the loans performing as agreed upon in the underlying
loan agreement.  These loans have a general reserve placed on them
based on the inherent risk of the loan, current market conditions, and the
historical performance of similar loans. The general reserves in this group are
approximately 1% primarily due to the loan type and management’s assessment of
historical performance of similar loans and to current market
conditions.





The Bank discontinues the accrual of
interest on loans 90 days or more past due, at which time all previously accrued
but uncollected interest is deducted from income.  As of the most
recent reported period, $4,430,000 in interest income would have been
recorded for the year ended December 31, 2008 if the loans had been current in
accordance with their original terms and had been outstanding throughout the
year ended December 31, 2008 or since their origination (if held for only part
of the fiscal year).  For the year ended December 31, 2008, $2,045,000
in interest income on such loans was actually included in net
income.  The following table sets forth information as to non-accrual
loans and other non performing assets.





At
      December 31,2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004(dollars
      in thousands)Loans
      accounted for on a non-accrual basis:Mortgage
      loans:One-to-four
      family real estate
                  
                  $
                  35,829
                  
                  
                  $
                  4,992
                  
                  
                  $
                  3,487
                  
                  
                  $
                  1,693
                  
                  
                  $
                  915Home
      equity lines of credit
                  
                  
                  189
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Commercial
                  
                  
                  3,047
                  
                  
                  
                  336
                  
                  
                  
                  98
                  
                  
                  
                  -
                  
                  
                  
                  -Land
                  
                  
                  15,721
                  
                  
                  
                  2,372
                  
                  
                  
                  2,342
                  
                  
                  
                  -
                  
                  
                  
                  24Non-mortgage
      loans:Consumer
                  
                  
                  9
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Commercial
      loans
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Total
      non-accrual loans
                  
                  $
                  54,795
                  
                  
                  $
                  7,700
                  
                  
                  $
                  5,927
                  
                  
                  $
                  1,693
                  
                  
                  $
                  939Accruing
      loans greater than 90 days past due
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Foreclosed
      real-estate
                  
                  $
                  6,317
                  
                  
                  $
                  2,993
                  
                  
                  $
                  970
                  
                  
                  $
                  -
                  
                  
                  $
                  -Total
      non-performing assets
                  
                  $
                  61,112
                  
                  
                  $
                  10,693
                  
                  
                  $
                  6,897
                  
                  
                  $
                  1,693
                  
                  
                  $
                  939Total
      non-accrual loans to net loans
                  
                  
                  6.1
                  %
                  
                  
                  0.9
                  %
                  
                  
                  0.7
                  %
                  
                  
                  0.2
                  %
                  
                  
                  0.1
                  %Allowance
      for loan losses to total non-performing loans,including
      loans contractually past due 90 days or more
                  
                  
                  27.0
                  %
                  
                  
                  140.0
                  %
                  
                  
                  152.3
                  %
                  
                  
                  443.3
                  %
                  
                  
                  632.1
                  %Total
      non-accrual and accruing loans greater than90
      days past due to total assets
                  
                  
                  5.5
                  %
                  
                  
                  0.8
                  %
                  
                  
                  0.7
                  %
                  
                  
                  0.2
                  %
                  
                  
                  0.1
                  %Total
      non-performing assets to total assets
                  
                  
                  6.2
                  %
                  
                  
                  1.1
                  %
                  
                  
                  0.8
                  %
                  
                  
                  0.2
                  %
                  
                  
                  0.1
                  %








Included in non-accrual one-to-four
family loans at December 31, 2008 were 46 loans totaling $18,811,000 to
consumers and 39 loans totaling $17,018,000 to builders.  Included in
non-accrual land loans at December 31, 2008 were 27 loans totaling $11,769,000
to consumers and 6 loans totaling $3,952,000 to builders.







13






Classified Assets and
Allowance for Loan Losses





Federal regulations provide for the
classification of loans and other assets, such as debt and equity securities,
considered by the OTS to be of lesser quality, as “substandard,” “doubtful” or
“loss assets.” An asset is considered substandard if the paying capacity and net
worth of the obligor or the collateral pledged, if any, inadequately protects
it.  Substandard assets include those characterized by the distinct
possibility that the insured institution will sustain some loss if the
deficiencies are not corrected.  Assets classified as doubtful have
all of the weaknesses inherent in those classified substandard with the added
characteristic that the weaknesses present make collection or liquidation in
full highly questionable and improbable, on the basis of currently existing
facts, conditions, and values.  Assets classified as loss assets are
those considered uncollectible and of such little value that their continuance
as assets without the establishment of a specific loss reserve is not
warranted.  Assets that do not currently expose the insured
institution to a sufficient degree of risk to warrant classification in one of
these categories but possess credit deficiencies or potential weakness are
required to be designated special mention by management.





When an
insured institution classifies problem assets as either substandard or doubtful,
it is required to establish general allowances for losses in an amount deemed
prudent by management.  General allowances represent loss allowances
which have been established to recognize the inherent risk associated with
lending activities, but which, unlike specific allowances, have not been
allocated to particular problem assets.  When an insured institution
classifies problem assets as loss assets, it is required either to establish a
specific allowance for losses equal to the full amount of the asset so
classified or to charge-off such amount.  An institution’s
determination as to the classification of its assets is subject to scrutiny by
the OTS, which can require the establishment of additional general or specific
loss allowances.  The Bank reviews monthly the assets in its portfolio
to determine whether any assets require classification in accordance with
applicable regulations.





Total classified loans as of December
31, 2008 were $83,964,000.  The allowance for loan losses as of
December 31, 2008 was $14,813,000, which was 1.6% of gross loans receivable and
27.0% of total non-performing loans.





[see
table on following page]





14


The
following table summarizes the allocation of the allowance for loan losses by
loan type and the percent of loans in each category compared to total loans at
the dates indicated:








2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Percentage
      of Loans
                
                
                
                
                
                Percentage
      of Loans
                
                
                
                
                
                Percentage
      of Loans
                
                
                
                
                
                Percentage
      of Loans
                
                
                
                
                
                Percentage
      of Loansin
      each
                
                
                
                
                
                in
      each
                
                
                
                
                
                in
      each
                
                
                
                
                
                in
      each
                
                
                
                
                
                in
      eachAllowance
                
                
                Category
      to
                
                
                Allowance
                
                
                Category
      to
                
                
                Allowance
                
                
                Category
      to
                
                
                Allowance
                
                
                Category
      to
                
                
                Allowance
                
                
                Category
      toAmount
                
                
                Total
      Loans
                
                
                Amount
                
                
                Total
      Loans
                
                
                Amount
                
                
                Total
      Loans
                
                
                Amount
                
                
                Total
      Loans
                
                
                Amount
                
                
                Total
      Loans(dollars
      in thousands)One
      to four family residential
                
                $
                5,765
                
                
                
                42.46
                %
                
                $
                3,378
                
                
                
                40.73
                %
                
                $
                2,202
                
                
                
                32.41
                %
                
                $
                1,706
                
                
                
                29.74
                %
                
                $
                2,000
                
                
                
                30.20
                %Multifamily
                
                
                42
                
                
                
                1.14
                %
                
                
                35
                
                
                
                0.76
                %
                
                
                33
                
                
                
                0.57
                %
                
                
                67
                
                
                
                0.49
                %
                
                
                20
                
                
                
                0.34
                %Commercial
      and industrial real estate
                
                
                3,080
                
                
                
                21.63
                %
                
                
                3,332
                
                
                
                22.41
                %
                
                
                2,512
                
                
                
                20.45
                %
                
                
                1,965
                
                
                
                17.73
                %
                
                
                1,009
                
                
                
                16.17
                %Construction
      and land acquisition anddevelopment
      loans
                
                
                2,559
                
                
                
                24.89
                %
                
                
                1,849
                
                
                
                24.29
                %
                
                
                2,253
                
                
                
                35.44
                %
                
                
                2,684
                
                
                
                42.07
                %
                
                
                2,577
                
                
                
                43.42
                %Land
                
                
                3,286
                
                
                
                8.96
                %
                
                
                2,027
                
                
                
                10.72
                %
                
                
                1,731
                
                
                
                10.10
                %
                
                
                882
                
                
                
                8.78
                %
                
                
                251
                
                
                
                8.54
                %Commercial,
      non-real estate
                
                
                77
                
                
                
                0.80
                %
                
                
                150
                
                
                
                0.83
                %
                
                
                288
                
                
                
                0.87
                %
                
                
                193
                
                
                
                1.00
                %
                
                
                70
                
                
                
                1.18
                %Other
                
                
                4
                
                
                
                0.12
                %
                
                
                10
                
                
                
                0.26
                %
                
                
                7
                
                
                
                0.16
                %
                
                
                8
                
                
                
                0.19
                %
                
                
                8
                
                
                
                0.15
                %Total
                
                $
                14,813
                
                
                
                100.00
                %
                
                $
                10,781
                
                
                
                100.00
                %
                
                $
                9,026
                
                
                
                100.00
                %
                
                $
                7,505
                
                
                
                100.00
                %
                
                $
                5,935
                
                
                
                100.00
                %








15





The
following table contains information with respect to Bancorp’s allowance for
loan losses for the periods indicated:





At
      or for the Year EndedDecember
      312008
                      
                      
                      2007
                      
                      
                      2006
                      
                      
                      2005
                      
                      
                      2004(dollars
      in thousands)Average
      loans outstanding, net
                      
                      $
                      893,030
                      
                      
                      $
                      858,305
                      
                      
                      $
                      819,038
                      
                      
                      $
                      738,028
                      
                      
                      $
                      600,030Total
      gross loans outstanding at end of period
                      
                      $
                      973,651
                      
                      
                      $
                      986,931
                      
                      
                      $
                      953,962
                      
                      
                      $
                      927,993
                      
                      
                      $
                      790,254Total
      net loans outstanding at end of period
                      
                      $
                      896,459
                      
                      
                      $
                      893,014
                      
                      
                      $
                      835,477
                      
                      
                      $
                      779,333
                      
                      
                      $
                      656,967Allowance
      balance at beginning of period
                      
                      $
                      10,781
                      
                      
                      $
                      9,026
                      
                      
                      $
                      7,505
                      
                      
                      $
                      5,935
                      
                      
                      $
                      4,832Provision
      for loan losses
                      
                      
                      7,481
                      
                      
                      
                      2,462
                      
                      
                      
                      1,561
                      
                      
                      
                      1,570
                      
                      
                      
                      1,200Actual
      charge-offs1-4
      family residential real estate
                      
                      
                      2,571
                      
                      
                      
                      270
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      97Other
                      
                      
                      878
                      
                      
                      
                      449
                      
                      
                      
                      40
                      
                      
                      
                      -
                      
                      
                      
                      -Total
      charge-offs
                      
                      
                      3,449
                      
                      
                      
                      719
                      
                      
                      
                      40
                      
                      
                      
                      -
                      
                      
                      
                      97RecoveriesTotal
      recoveries
                      
                      
                      -
                      
                      
                      
                      12
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Net
      charge offs
                      
                      
                      3,449
                      
                      
                      
                      707
                      
                      
                      
                      40
                      
                      
                      
                      -
                      
                      
                      
                      97Allowance
      balance at end of period
                      
                      $
                      14,813
                      
                      
                      $
                      10,781
                      
                      
                      $
                      9,026
                      
                      
                      $
                      7,505
                      
                      
                      $
                      5,935Net
      charge offs as a percent of average loans
                      
                      
                      0.39
                      %
                      
                      
                      0.08
                      %
                      
                      
                      0.00
                      %
                      
                      
                      0.00
                      %
                      
                      
                      0.02
                      %Allowance
      for loan losses to total gross loans at end of period
                      
                      
                      1.52
                      %
                      
                      
                      1.09
                      %
                      
                      
                      0.95
                      %
                      
                      
                      0.81
                      %
                      
                      
                      0.75
                      %Allowance
      for loan losses to net loans at end of period
                      
                      
                      1.65
                      %
                      
                      
                      1.21
                      %
                      
                      
                      1.08
                      %
                      
                      
                      0.96
                      %
                      
                      
                      0.90
                      %








Investment
Activities





Federal thrift institutions, such as
the Bank, have authority to invest in various types of liquid assets, including
United States Treasury obliga­tions and securities of various federal
agencies, certificates of deposit at insured banks, bankers' acceptances and
federal funds.  As a member of the FHLB System, the Bank must maintain
minimum levels of liquid assets specified by the OTS, which vary from time to
time.  Subject to various regulatory restrictions, federal thrift
institutions may also invest a portion of their assets in certain commercial
paper, corporate debt securities and mutual funds whose assets conform to the
investments that a federal thrift institution is authorized to make
directly.





The carrying amounts of the Bank’s
investment securities held to maturity, as of the dates indicated are presented
in the following table:




At
      December 31,2008
                  2007
                  2006(dollars
      in thousands)FHLB
      notes
                  $-
                  $1,000
                  $5,000Mortgage-backed
      securities
                  1,345
                  1,383
                  2,271Total
      Investment Securities Held to Maturity
                  $1,345
                  $2,383
                  $7,271







16




Investment
Scheduled Maturity Table





As of
December 31, 2008





More
      than One  to
                      
                      More
      than Five  to
                      
                      More
      thanOne
      Year or Less
                      
                      Five
      Years
                      
                      Ten
      Years
                      
                      Ten
      Years
                      
                      Total
      Investment SecuritiesCarrying
                      Average
                      
                      Carrying
                      Average
                      
                      Carrying
                      Average
                      
                      Carrying
                      Average
                      
                      Carrying
                      Average
                      FairAmount
                      Yield
                      
                      Amount
                      Yield
                      
                      Amount
                      Yield
                      
                      Amount
                      Yield
                      
                      Amount
                      Yield
                      Value(dollars
      in thousands)Mortgage-backed
      securities
                      $-
                      -
                      
                      $-
                      -
                      
                      $-
                      -
                      
                      $1,345
                      5.58%
                      
                      $1,345
                      5.58%
                      $1,329












17


Deposits





Deposits are attracted principally
from within the Bank’s primary market areas through the offering of a variety of
deposit instruments, including passbook and statement accounts and certificates
of deposit ranging in terms from three months to five years.  Deposit
account terms vary, principally on the basis of the minimum balance required,
the time periods the funds must remain on deposit and the interest
rate.  The Bank also offers individual retirement
accounts.





The Bank’s policies are designed
primarily to attract deposits from local residents rather than to solicit
deposits from areas outside the Bank’s primary markets.  Interest
rates paid, maturity terms, service fees and withdrawal penalties are
established by the Bank on a periodic basis.  Determination of rates
and terms are predicated upon funds acquisition and liquidity requirements,
rates paid by competitors, growth goals and federal regulations.





Deposits in the Bank as of December
31, 2008, 2007 and 2006 consisted of savings programs described
below:





2008
                  
                  
                  2007
                  
                  
                  2006(dollars
      in thousands)NOW
      accounts
                  
                  $
                  12,813
                  
                  
                  $
                  11,152
                  
                  
                  $
                  9,314Money
      market accounts
                  
                  
                  44,012
                  
                  
                  
                  87,688
                  
                  
                  
                  89,120Passbooks
                  
                  
                  53,319
                  
                  
                  
                  14,891
                  
                  
                  
                  18,526Certificates
      of deposit
                  
                  
                  554,747
                  
                  
                  
                  523,698
                  
                  
                  
                  490,865Non-interest
      bearing accounts
                  
                  
                  18,975
                  
                  
                  
                  15,344
                  
                  
                  
                  18,699Total
      deposits
                  
                  $
                  683,866
                  
                  
                  $
                  652,773
                  
                  
                  $
                  626,524





The following table contains
information pertaining to the certificates of deposit held by the Bank in excess
of $100,000 as of December 31, 2008.





Jumbo
      Certificatesof
      DepositTime
      Remaining Until Maturity
                  
                  (dollars
      in thousands)Less
      than three months
                  
                  $
                  46,8913
      months to 6 months
                  
                  
                  57,7196
      months to 12 months
                  
                  
                  84,943Greater
      than 12 months
                  
                  
                  42,106Total
                  
                  $
                  231,659













18





Liquidity and
Asset/Liability Management





Two major objectives of asset and
liability management are to maintain adequate liquidity and to control the
interest sensitivity of the balance sheet.





Liquidity is the measure of a
company’s ability to maintain sufficient cash flow to fund operations and to
meet financial obligations to depositors and borrowers.  Liquidity is
provided by the ability to attract and retain deposits and by principal and
interest payments on loans and maturing securities in the investment
portfolio.  A strong core deposit base, supplemented by other deposits
of varying maturities and rates, contributes to the Bank’s
liquidity.





Management believes that funds
available through short-term borrowings and asset maturities are considered
adequate to meet all anticipated needs, and management is continually monitoring
the Bank’s liquidity position to meet projected needs.





Interest rate sensitivity is
maintaining the ability to reprice interest earning assets and interest bearing
liabilities in relationship to changes in the general level of interest
rates.  Management attributes interest rate sensitivity to a steady
net interest margin through all phases of interest rate
cycles.  Management attempts to make the necessary adjustments to
constrain adverse swings in net interest income resulting from interest rate
movements through gap analysis and income simulation modeling
techniques.





Short Term
Borrowings





The Bank has an available line of
credit, secured by various loans in its portfolio, in the amount of thirty
percent (30%) of its total assets, with the FHLB-Atlanta.  As of
December 31, 2008, the total available line of credit with the FHLB-Atlanta for
short term and long-term borrowings was $303,971,000.  The Bank, from
time to time, utilizes the line of credit when interest rates are more favorable
than obtaining deposits from the public.  The following table sets
forth short-term borrowings with the FHLB-Atlanta, with original maturities of
one year or less.







Years
      ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006(dollars
      in thousands)Short
      term borrowingsAverage
      balance outstanding during the period
                  
                  $
                  1,667
                  
                  
                  $
                  10,417
                  
                  
                  $
                  8,250Maximum
      amount outstanding at any month-end duringthe
      period
                  
                  
                  10,000
                  
                  
                  
                  25,000
                  
                  
                  
                  26,000Weighted
      average interest rate during the period
                  
                  
                  3.74
                  %
                  
                  
                  4.68
                  %
                  
                  
                  5.31
                  %Total
      short term borrowings at period end
                  
                  
                  -
                  
                  
                  
                  15,000
                  
                  
                  
                  18,000Weighted
      average interest rate at period end
                  
                  
                  -
                  
                  
                  
                  4.40
                  %
                  
                  
                  5.41
                  %







19


Employees





As of December 31, 2008, Bancorp and
its subsidiaries had approximately 106 full-time equivalent
employees.    Bancorp’s employees are not represented by any
collective bargaining group, and management considers its relations with its
employees to be excellent.





Hyatt
Commercial





Hyatt Commercial is a real estate
brokerage company specializing in commercial real estate sales, leasing and
property management.





SBI Mortgage
Company





SBI is a subsidiary of Bancorp that
has engaged in the origination of mortgages not suitable for the
Bank.  It owns subsidiary companies that purchase real estate for
investment purposes.  As of December 31, 2008, SBI had $2,664,000 in
outstanding mortgage loans and it had $468,000 invested in subsidiaries, which
funds were held in cash, pending potential acquisition of investment real
estate.





Crownsville Development
Corporation





Crownsville, which is doing business
as Annapolis Equity Group, is a subsidiary of SBI and is engaged in the business
of acquiring real estate for investment and syndication purposes.





HS West,
LLC





HS West, LLC (“HS”) is a subsidiary
of the Bank, and constructed a building in Annapolis, Maryland that serves as
Bancorp’s and the Bank’s administrative headquarters. A branch office of the
Bank is also located in the building.  In addition, HS leases space to
four unrelated companies and to a law firm of which the President of Bancorp and
the Bank is a partner.





Homeowners Title and Escrow
Corporation





Homeowners Title and Escrow
Corporation, is a subsidiary of the Bank, and was engaged in the business of
conducting loan settlements for the Bank.  During 2008, Homeowners
Title and Escrow Corporation ceased operations.







20





Regulation




The financial services industry in
the Bank’s market area is highly competitive, including competition from
commercial banks, savings banks, credit unions, finance companies and non-bank
providers of financial services. Several of the Bank’s competitors have legal
lending limits that exceed that of the Bank’s, as well as funding sources in the
capital markets that exceeds the Bank’s availability. The increased competition
has resulted from a changing legal and regulatory climate, as well as from the
economic climate.





General





Savings and loan holding companies
and savings associations are extensively regulated under both federal and state
law.  This regulation is intended primarily to protect depositors and
the Deposit Insurance Fund (“DIF”), and not the stockholders of
Bancorp.  The summary below describes briefly the regulation that is
applicable to Bancorp and the Bank, does not purport to be complete and is
qualified in its entirety by reference to applicable laws and
regulations.





Regulation
of Bancorp




General.  As
a unitary savings and loan holding company, Bancorp is required to register and
file reports with the OTS and is subject to regulation and examination by the
OTS.  In addition, the OTS has enforcement authority over Bancorp and
its subsidiaries, which also permits the OTS to restrict or prohibit activities
that are determined to be a serious risk to the subsidiary savings
association.





Activities
Restriction Test.  As a unitary savings and loan holding
company, Bancorp generally is not subject to activity restrictions, provided the
Bank satisfies the Qualified Thrift Lender (“QTL”) test. The termination of the
“unitary thrift holding company exemption” in 1999 did not affect Bancorp
because Bancorp was grandfathered under the law.  Under certain
circumstances, Bancorp could lose its grandfathered status.  If the
Bank failed to meet the QTL test, then Bancorp would become subject to the
activities restrictions applicable to multiple savings and loan holding
companies and, unless the Bank qualified as a QTL within one year thereafter,
Bancorp would be required to register as, and would become subject to the
restrictions applicable to, a bank holding company. Additionally, if Bancorp
were to acquire control of another savings association, either through merger or
other combination with the Bank or other than in a supervisory acquisition where
the acquired association also met the QTL test, Bancorp would thereupon become a
multiple savings and loan holding company and would thereafter be subject to
further restrictions on its activities.  Bancorp presently intends to
continue to operate as a unitary savings and loan holding company.





Restrictions on
Acquisitions.  Except under limited circumstances, savings and
loan holding companies, such as Bancorp, are prohibited from acquiring, without
prior approval of the OTS, (i) more than 5% of the voting shares of a savings
association or a holding company which is not a subsidiary thereof or (ii)
acquiring control of an uninsured institution, or retaining, for more than one
year after the date of any savings association becomes uninsured, control of
such association.  In evaluating proposed acquisitions of savings
institutions by holding companies, the OTS considers the financial and
managerial resources and future prospects of the holding company and the target
institution, the effect of the acquisition on the risk to the DIF, the
convenience and the needs of the community and competitive factors.





No director or
officer of a savings and loan holding company or person owning or controlling by
proxy or otherwise more than 25% of such company’s stock, may acquire control of
any savings association, other than a subsidiary savings association, or of any
other savings and loan holding company, without written approval of the OTS.
Certain individuals, including Alan J. Hyatt, Louis Hyatt, and Melvin Hyatt, and
their respective spouses (“Applicants”), filed an Application for Notice of
Change In Control (“Notice”) in April 2001 pursuant to 12 CFR Section
574.3(b).  The Notice called for the Applicants to acquire up to
32.32% of Bancorp’s issued and outstanding shares of stock of Bancorp by April
16, 2002.  The OTS approved requests by the Applicants to extend the
time to consummate such acquisition of shares to December 12,
2009.  The Applicants currently own approximately 29.35% of the total
outstanding shares of Bancorp as of December 31, 2008.






21






The OTS is prohibited from approving
any acquisition that would result in a multiple savings and loan holding company
controlling savings institutions in more than one state, subject to two
exceptions: (i) the approval of interstate supervisory acquisitions by savings
and loan holding companies; and (ii) the acquisition of a savings institution in
another state if the laws of the state of the target savings institution
specifically permit such acquisitions.  The states vary in the extent
to which they permit interstate savings and loan holding company
acquisitions.





Federal
Securities Law.  Bancorp’s securities are registered with the
Securities and Exchange Commission under the Securities Exchange Act of 1934, as
amended.  As such, Bancorp is subject to the information, proxy
solicitation, insider trading, and other requirements and restrictions of the
Securities Exchange Act of 1934.





Financial
Services Modernization Legislation.  In November 1999, the
Gramm-Leach-Bliley Act of 1999 (“GLBA”) was enacted. The GLBA generally permits
banks, other depository institutions, insurance companies and securities firms
to enter into combinations that result in a single financial services
organization to offer customers a wider array of financial services and products
so long as they do not pose a substantial risk to the safety and soundness of
depository institutions or the financial system generally.





The GLBA may have the result of
increasing the amount of competition that Bancorp and the Bank face from larger
institutions and other types of companies offering financial products, many of
which may have substantially more financial resources than Bancorp and the
Bank.





Troubled Assets
Relief Program.  During the fourth quarter of 2008, the U.S.
Department of the Treasury (the “Treasury”) instituted the Troubled Assets
Relief Program (the “TARP”) pursuant to the Emergency Economic Stabilization Act
of 2008 (the “EESA”) in an effort to stabilize the nation’s capital
markets.  To carry out the TARP, the Treasury established the Capital
Purchase Program (the “CPP”) which financial institutions may participate in on
a voluntary basis.





Bancorp
elected to participate in the CPP and entered into agreements to sell certain
securities to the Treasury on November 21, 2008 (the “CPP
Agreements”).  As a result of, and condition to, the CPP Agreements,
Bancorp will be subject to certain restrictions, requirements and limitations
related to executive compensation (which are generally applicable to the CEO,
CFO and three next most highly compensated executive officers of Bancorp),
dividend payments and stock repurchase activities.





Maryland
Corporation Law.  Bancorp is incorporated under the laws of the
State of Maryland, and is therefore subject to regulation by the state of
Maryland.  The rights of Bancorp’s stockholders are governed by the
Maryland General Corporation Law.




Regulation
of the Bank




General.  As
a federally chartered, DIF-insured savings association, the Bank is subject to
extensive regulation by the OTS and the FDIC.  Lending activities and
other investments of the Bank must comply with various statutory and regulatory
requirements.  The Bank is also subject to certain reserve
requirements promulgated by the FRB.  The OTS, in conjunction with the
FDIC, regularly examines the Bank and prepares reports for the consideration of
the Bank’s Board of Directors on any deficiencies found in the operations of the
Bank.  The relationship between the Bank and depositors and borrowers
is also regulated by federal and state laws, especially in such matters as the
ownership of savings accounts and the form and content of mortgage documents
utilized by the Bank.




22






The Bank must file reports with the
OTS and the FDIC concerning its activities and financial condition, in addition
to obtaining regulatory approvals prior to entering into certain transactions
such as mergers with or acquisitions of other financial
institutions.  Any change in such regulations, whether by the OTS, the
FDIC, the FRB or the Congress could have a material adverse impact on Bancorp,
the Bank, and their operations.





Regulatory
Capital Requirements.  OTS regulations require that the Bank
meet three minimum requirement standards including: (i) tangible capital equal
to at least 1.5% of adjusted total assets; (ii) a leverage ratio consisting of
Tier I or “core” capital equal to at least 4% (or 3%, if the Bank is rated 1
CAMELS under the OTS examination rating system) of adjusted total assets; and
(iii) risk-based capital equal to at least 8% of total risk-weighted
assets.





Tier I, or core capital is defined as
common stockholder’s equity, non-cumulative perpetual preferred stock and
related surplus, minority interests in the equity accounts of consolidated
subsidiaries and certain non-withdrawable accounts or pledged deposits. Tier I
(Core) capital is generally reduced by the amount of the saving’s institution’s
intangible assets. Limited exceptions to the deduction of intangible assets
exist for certain mortgage servicing rights and credit card relationships and
qualifying supervisory goodwill.  In December of 2008, federal banking
and thrift regulatory agencies approved a final rule permitting a banking
institution to reduce the amount of goodwill that it must deduct from Tier I
capital by the amount of any associated deferred tax liability.





Tangible capital is generally defined
the same as core capital but does not include an exception for qualifying
supervisory goodwill and is reduced by the amount of all the savings
association’s intangible assets with only a limited exception for certain
mortgage servicing rights.  Both core and tangible capital are further
reduced by an amount equal to a savings institution’s debt and equity
investments in subsidiaries engaged in activities not permissible for national
banks (other than subsidiaries engaged in activities undertaken as agent for
customers or in mortgage banking activities and subsidiary depository
institutions or their holding companies).  Investments in and
extensions of credit to such subsidiaries are required to be fully netted
against tangible and core capital.  At December 31, 2008, the Bank had
no such investments.





Total capital equals the sum of Tier
I (Core) capital and supplementary capital, to the extent that supplementary
capital does not exceed Tier I (Core) capital.  Supplementary capital
includes, among other items, cumulative perpetual preferred stock, perpetual
subordinate debt, mandatory convertible subordinate debt, intermediate-term
preferred stock, the portion of allowance for loan losses not designated for
specific loan losses (up to 1.25% of risk-weighted assets) and up to 45% of
unrealized gains on equity securities.  For purposes of determining
total capital, a savings institution’s assets are reduced by the amount of
capital instruments held by other depository institutions pursuant to reciprocal
arrangements and by the amount of the institution’s equity investments (other
than those deducted from core and tangible capital) and its high loan-to-value
ratio land loans and non-residential construction loans.





A savings institution’s risk based
capital requirement is measured against risk-weighted assets, which equal the
sum of each on-balance sheet asset and the credit-equivalent amount of each
off-balance-sheet item after being multiplied by an assigned risk
weight.  These risk weights range from 0% for cash to 100% for
delinquent loans, property acquired through foreclosure, commercial loans, and
certain other assets.










23


As shown below, the Bank’s regulatory
capital exceeded all minimum regulatory capital requirements applicable to it as
of December 31, 2008.








Actual
                
                
                Required
      For Capital
                  Adequacy
      Purposes
                
                
                Required
      To Be Well Capitalized Under Prompt Corrective Action
      ProvisionsAmount
                
                
                %
                
                
                Amount
                
                
                %
                
                
                Amount
                
                
                %(dollars
      in thousands)December 31, 2008Tangible
      (1)
                
                $
                132,890
                
                
                
                13.5
                %
                
                $
                14,743
                
                
                
                1.50
                %
                
                
                N/A
                
                
                
                N/ATier
      I capital (2)
                
                
                132,890
                
                
                
                16.9
                %
                
                
                N/A
                
                
                
                N/A
                
                
                $
                47,047
                
                
                
                6.00
                %Core
      (1)
                
                
                132,890
                
                
                
                13.5
                %
                
                
                39,314
                
                
                
                4.00
                %
                
                
                49,142
                
                
                
                5.00
                %Total
      (2)
                
                
                142,199
                
                
                
                18.1
                %
                
                
                62,730
                
                
                
                8.00
                %
                
                
                78,412
                
                
                
                10.00
                %December 31, 2007Tangible
      (1)
                
                $
                107,734
                
                
                
                11.3
                %
                
                $
                14,321
                
                
                
                1.50
                %
                
                
                N/A
                
                
                
                N/ATier
      I capital (2)
                
                
                107,734
                
                
                
                13.7
                %
                
                
                N/A
                
                
                
                N/A
                
                
                $
                47,144
                
                
                
                6.00
                %Core
      (1)
                
                
                107,734
                
                
                
                11.3
                %
                
                
                38,190
                
                
                
                4.00
                %
                
                
                47,737
                
                
                
                5.00
                %Total
      (2)
                
                
                117,205
                
                
                
                14.9
                %
                
                
                62,859
                
                
                
                8.00
                %
                
                
                78,573
                
                
                
                10.00
                %


____________


(1)  To
adjusted total assets.


(2)  To
risk-weighted assets.





Enforcement.The OTS has primary enforcement responsibility over federal savings
institutions and has the authority to bring enforcement action against all
“institution-affiliated parties,” including stockholders, attorneys, appraisers
and accountants who knowingly or recklessly participate in wrongful action
likely to have an adverse effect on an insured institution.  Formal
enforcement actions by the OTS may range from issuance of a capital directive or
cease and desist order, to removal of officers or directors of the institution
and the appointment of a receiver or conservator.  The FDIC also has
the authority to terminate deposit insurance or recommend to the director of the
OTS that enforcement action be taken with respect to a particular savings
institution.  If action is not taken by the director of the OTS, the
FDIC has authority to take action under specific circumstances.





Safety and
Soundness Standards.  Federal law requires each federal banking
agency, including the OTS, to prescribe to certain standards relating to
internal controls, information and internal audit systems, loan documentation,
credit underwriting, interest rate risk exposure, asset growth, compensation,
fees and benefits.  In general, the guidelines require, among other
things, appropriate systems and practices to identify and manage the risks and
exposures specified in the guidelines.  The guidelines further provide
that savings institutions should maintain safeguards to prevent the payment of
compensation, fees and benefits that are excessive or that could lead to
material financial loss, and should take into account factors such as comparable
compensation practices at comparable institutions.  If the OTS
determines that a savings institution is not in compliance with the safety and
soundness guidelines, it may require the institution to submit an acceptable
plan to achieve compliance with the guidelines.  A savings institution
must submit an acceptable compliance plan to the OTS within 30 days of receipt
of a request for such a plan.  Failure to submit or implement a
compliance plan may subject the institution to regulatory
sanctions.





Prompt Corrective
Action.  Under the prompt corrective action regulations, the
OTS is required and authorized to take supervisory actions against
undercapitalized savings associations.  The risk-based capital,
leverage capital, and tangible capital ratios are used to determine an
institution’s capital classification.  For this purpose, a savings
association is placed into one of the following five categories dependent on
their respective capital ratios:





·
            “well
      capitalized” (at least 5% leverage capital, 6% Tier I risk-based capital
      and 10% total risk-based capital);


·
            “adequately
      capitalized” (at least 4% leverage capital, 4% Tier I risk-based capital
      and 8% total risk-based capital);


·
            “undercapitalized”
      (less than 4% leverage capital, 4% Tier I risk-based capital or 8% total
      risk-based capital);


·
            “significantly
      undercapitalized” (less than 3% leverage capital, 3% Tier I risk-based
      capital or 6% total risk-based capital);
and


·
            “critically
      undercapitalized” (less than 2% tangible
  capital).







24




Generally,
the banking regulator is required to appoint a receiver or conservator for an
institution that is “critically undercapitalized”.  The regulation
also provides that a capital restoration plan must be filed with the OTS within
45 days of the date an institution receives notice that it is
“undercapitalized”, “significantly undercapitalized” or “critically
undercapitalized”.  In addition, numerous mandatory supervisory
actions become immediately applicable to the institution, including, but not
limited to, restrictions on growth, investment activities, payment of dividends
and other capital distributions, and affiliate transactions.  The OTS
may also take any one of a number of discretionary supervisory actions against
the undercapitalized institutions, including the issuance of a capital directive
and the replacement of senior executive officers and directors.





As of December 31, 2008, the Bank met
the capital requirements of a “well capitalized” institution under applicable
OTS regulations.





Premiums for
Deposit Insurance.  The Bank’s deposits are insured up to
applicable limits by the DIF of the FDIC.





The FDIC regulations assess insurance
premiums based on an institution’s risk.  Under this assessment
system, the FDIC evaluates the risk of each financial institution based on its
supervisory rating, financial ratios, and long-term debt issuer rating. In 2008,
the assessment ranged from 5 to 43 basis points of an institution's deposits,
depending on its risk category.





Federal law requires the FDIC to
establish a deposit reserve ratio for the deposit fund of between 1.15% and
1.50% of estimated insured deposits.  Due to several bank failures in
2008, the current FDIC ratio has fallen below the statutory minimum and was
1.01% as of June 30, 2008.  As required by law, the FDIC adopted a
restoration plan in October of 2008 that would increase the deposit reserve
ratio to the 1.15% threshold within five years.  On February 27, 2009,
the FDIC took action to extend the restoration plan horizon to seven
years.





On December 16, 2008, the FDIC
adopted a final rule increasing risk-based assessment rates uniformly by 7 basis
points.  Under this rule, FDIC assessments will range from 12 to 50
basis points of assessable deposits during the first quarter of 2009 with the
expectation that most institutions would be charged between 12 and 14 basis
points.





The amended restoration plan was
accompanied by a final rule that sets assessment rates and makes adjustments
that improve how the assessment system differentiates for risk. Under the final
rule, banks in the best risk category will pay initial base rates ranging from
12 to 16 cents per $100 on an annual basis, beginning on April 1,
2009.





The FDIC also adopted an interim rule
imposing a 20 basis point emergency special assessment on the industry on June
30, 2009. The assessment is to be collected on September 30, 2009. The interim
rule would also permit the FDIC to impose an emergency special assessment after
June 30, 2009, of up to 10 basis points if necessary to maintain public
confidence in federal deposit insurance.





In response to the economic
turbulence of 2008, deposit insurance per account has been raised to $250,000 of
all types of accounts until January 1, 2010.  Further, the FDIC has
adopted a Temporary Liquidity Guarantee Program pursuant to which, for a fee,
non-interest bearing transaction accounts would be insured without limit through
December 31, 2009 and certain unsecured debt issued by institutions and their
holding companies on or after October 14, 2008 through and including June 30,
2009 would be guaranteed by the FDIC through June 30, 2012.





The FDIC is authorized to terminate a
depository institution’s deposit insurance upon a finding by the FDIC that the
institution’s financial condition is unsafe or unsound or that the institution
has engaged in unsafe or unsound practices or has violated any applicable rule,
regulation, order or condition enacted or imposed by the institution’s
regulatory agency.  The termination of deposit insurance for the Bank
could have a material adverse effect on Bancorp’s earnings, depending on the
collective size of the particular institutions involved.






25






All
FDIC-insured depository institutions must pay an annual assessment to provide
funds for the payment of interest on bonds issued by the Financing Corporation,
a federal corporation chartered under the authority of the Federal Housing
Finance Board.  The bonds, commonly referred to as Financing
Corporation (“FICO”) bonds, were issued to capitalize the Federal Savings and
Loan Insurance Corporation.  The annual FICO assessment rate as of the
first quarter of 2009 is 1.14 basis points (i.e. $0.0114 for every $100 of
assessable deposits).  The FICO assessments are adjusted quarterly to
reflect changes in the assessment bases of the FDIC’s insurance funds and do not
vary depending on a depository institution’s capitalization or supervisory
evaluations.





The FDIC has authority to increase
insurance assessments.  A significant increase in insurance premiums
would likely have an adverse effect on the operating expenses of the
Bank.





Privacy.  Federal
banking rules limit the ability of banks and other financial institutions to
disclose non-public information about consumers to nonaffiliated third
parties.  Pursuant to these rules, financial institutions must
provide:





·
            Initial
      and annual notices to customers about their privacy policies, describing
      the conditions under which they may disclose nonpublic personal
      information to nonaffiliated third parties and affiliates;
    and


·
            a
      reasonable method for customers to “opt out” of disclosures to
      nonaffiliated third parties.





Since the GLBA’s enactment, a number
of states have implemented their own versions of privacy laws.  The
Bank has implemented its privacy policies in accordance with applicable
law.





Loans-to-One
Borrower Limitations.  With certain limited exceptions, the
maximum amount that a savings association or a national bank may lend to any
borrower (including certain related entities of the borrower) may not exceed 15%
of the unimpaired capital and surplus of the institution, plus an additional 10%
of unimpaired capital and surplus for loans fully secured by readily marketable
collateral.  Savings associations are additionally authorized to make
loans to one borrower, for any purpose, in an amount not to exceed $500,000 or,
by order of the Director of the OTS, in an amount not to exceed the lesser of
$30,000,000 or 30% of unimpaired capital and surplus to develop residential
housing, provided:





·
            the
      purchase price of each single-family dwelling in the development does not
      exceed $500,000;


·
            the
      savings association is in compliance with its fully phased-in capital
      requirements;


·
            the
      loans comply with applicable loan-to-value requirements;
    and


·
            the
      aggregate amount of loans made under this authority does not exceed 150%
      of unimpaired capital and surplus.





At December 31, 2008, the Bank’s
loans-to-one-borrower limit was $19,934,000 based upon the 15% of unimpaired
capital and surplus measurement.  At December 31, 2008, the Bank’s two
largest lending relationships had an outstanding balance of $7,158,000 secured
by commercial property located in Annapolis, Maryland and a $7,000,000 loan
consisting of a line of credit secured by assignments of notes, Deeds of Trust,
pledged stock and certificates of deposit.  The loans were performing
in accordance with their terms.





Qualified Thrift
Lender Test. Savings associations must meet a QTL test, which test may be
met either by maintaining at least 65% of its portfolio assets in qualified
thrift investments or meeting the definition of a “domestic building and loan
association” as defined in the Code, in either case in at least nine of the most
recent twelve month period.  “Portfolio Assets” generally means total
assets of a savings institution, less the sum of specified liquid assets up to
20% of total assets, goodwill and other intangible assets, and the value of
property used in the conduct of the savings association’s
business.  Qualified thrift investments are primarily residential
mortgages and related investments, including certain mortgage-related
securities.  Associations that fail to meet the QTL test must either
convert to a bank charter or operate under specified restrictions. As of
December 31, 2008, the Bank was in compliance with its QTL requirement and met
the definition of a domestic building and loan association.






26




Affiliate
Transactions. Generally, transactions between a savings bank or its
subsidiaries and its affiliates (i.e. companies that control the Bank or are
under common control with the Bank) must be on terms favorable to the Bank as
comparable transactions with non-affiliates.  In addition, certain of
these transactions are restricted to a percentage of the Bank’s capital and are
subject to specific collateral requirements.





The bank’s authority to extend credit
to executive officers, directors, trustees and 10% stockholders, as well as
entities under such person’s control, is currently governed by Section 22(g) and
22(h) of the Federal Reserve Act and Regulation O promulgated by the
FRB.  Among other things, these regulations generally require such
loans to be made on terms substantially similar to those offered to unaffiliated
individuals, place limits on the amounts of the loans the Bank may make to such
persons based, in part, on the Bank’s capital position, and require certain
board of directors’ approval procedures to be followed.





Capital
Distribution Limitations. OTS regulations impose limitations upon all
capital distributions by savings associations, such as cash dividends, payments
to repurchase or otherwise acquire its shares, payments to shareholders of
another institution in a cash-out merger and other distributions charged against
capital.





The OTS regulations require a savings
association to file an application for approval of a capital distribution
if:





·
            the
      association is not eligible for expedited treatment of its filings with
      the OTS;


·
            the
      total amount of all of capital distributions, including the proposed
      capital distribution, for the applicable calendar year exceeds its net
      income for that year to date plus retained net income for the preceding
      two years;


·
            the
      association would not be at least adequately capitalized under the prompt
      corrective action regulations of the OTS following the distribution;
      or


·
            the
      proposed capital distribution would violate any applicable statute,
      regulation, or agreement between the savings association and the OTS, or
      the FDIC, or violate a condition imposed on the savings association in an
      OTS-approved application or notice.





In addition, a savings association
must give the OTS notice of a capital distribution if the savings association is
not required to file an application, but:





·
            would
      not be well capitalized under the prompt corrective action regulations of
      the OTS following the distribution;


·
            the
      proposed capital distribution would reduce the amount of or retire any
      part of the savings association's common or preferred stock or retire any
      part of debt instruments like notes or debentures included in capital,
      other than regular payments required under a debt instrument approved by
      the OTS; or


·
            the
      savings association is a subsidiary of a savings and loan holding
      company.





The OTS may prohibit a proposed
capital distribution that would otherwise be permitted if the OTS determines
that the distribution would constitute an unsafe or unsound
practice.  In addition, the Federal Deposit Insurance Act provides
that an insured depository institution shall not make any capital distribution,
if after making such distribution the institution would be
undercapitalized.





Branching.Under OTS
branching regulations, the Bank is generally authorized to open branches within
or beyond the State of Maryland if the Bank (1) qualifies as a “domestic
building and loan association” under the Code, which qualification requirements
are similar to those for a Qualified Thrift Lender under the Home Owners’ Loan
Act, and (2) publishes public notice at least 30 days before opening a branch
and no one opposes the branch.  If a comment in opposition to a branch
opening is filed and the OTS determines the comment to be relevant to the
approval process standards, and to require action in response, the OTS may,
among other things, require a branch application or elect to hold a meeting with
the Bank and the person who submitted the comment.  The OTS authority
preempts any state law purporting to regulate branching by federal savings
banks.





Community
Reinvestment Act and the Fair Lending Laws.  Savings
associations have a responsibility under the Community Reinvestment Act and
related regulations of the OTS to help meet the credit needs of their
communities, including low- and moderate-income neighborhoods. In addition, the
Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from
discriminating in their lending practices on the basis of characteristics
specified in those statutes. An institution's failure to comply with the
provisions of the Community Reinvestment Act could, at a minimum, result in
regulatory restrictions on its activities and the denial of applications. In
addition, an institution's failure to comply with the Equal Credit Opportunity
Act and the Fair Housing Act could result in the OTS, other federal regulatory
agencies as well as the Department of Justice taking enforcement
actions.  Based on an examination conducted May 30, 2006, the Bank
received a satisfactory rating.






27






Federal Home Loan
Bank System. The Bank is a member of the FHLB-Atlanta. Among other
benefits, each FHLB serves as a reserve or central bank for its members within
its assigned region. Each FHLB is financed primarily from the sale of
consolidated obligations of the FHLB system. Each FHLB makes available loans or
advances to its members in compliance with the policies and procedures
established by the Board of Directors of the individual FHLB.





Under the capital plan of the
FHLB-Atlanta as of December 31, 2008, the Bank was required to own at least
$8,693,600 of the capital stock of the FHLB-Atlanta.  As of such date,
the Bank owned $8,694,000 of the capital stock of the FHLB-Atlanta and was in
compliance with the capital plan requirements.





Federal Reserve
System.  The FRB requires all depository institutions to
maintain non-interest bearing reserves at specified levels against their
transaction accounts (primarily checking, NOW, and Super NOW checking accounts)
and non-personal time deposits.  At December 31, 2008, the Bank was in
compliance with these requirements.





Activities of
Subsidiaries. A savings association seeking to establish a new
subsidiary, acquire control of an existing company or conduct a new activity
through a subsidiary must provide 30 days prior notice to the FDIC and the OTS
and conduct any activities of the subsidiary in compliance with regulations and
orders of the OTS. The OTS has the power to require a savings association to
divest any subsidiary or terminate any activity conducted by a subsidiary that
the OTS determines to pose a serious threat to the financial safety, soundness
or stability of the savings association or to be otherwise inconsistent with
sound banking practices.





Tying
Arrangements. Federal savings associations are prohibited, subject to
some exceptions, from extending credit to or offering any other services, or
fixing or varying the consideration for such extension of credit or service, on
the condition that the customer obtain some additional service from the
institution or its affiliates or not obtain services of a competitor of the
institution.





Item 1A.  Risk
Factors





Unless
the context indicates otherwise, all references to “we,” “us,” “our” in this
subsection “Risk Factors” refer to the Bancorp and its
subsidiaries.  You should carefully consider the risks and
uncertainties described below as well as elsewhere in this Annual Report on Form
10-K. If any of the risks or uncertainties actually occurs, our business,
financial condition or results of future operations could be materially
adversely affected. The risks and uncertainties described in this Form 10-K are
not the only ones we face.  Additional risks and uncertainties that we
are unaware of, or that we currently deem immaterial, also may become important
factors that affect us.  This Annual Report on Form 10-K contains
forward-looking statements that involve risks and uncertainties. Our actual
results could differ materially from those anticipated in the forward-looking
statements as a result of many factors, including the risks faced by us
described below and elsewhere in this Annual Report on Form 10-K.





We
may be adversely affected by changes in economic and political conditions and by
governmental monetary and fiscal policies.





The
thrift industry is affected, directly and indirectly, by local, domestic, and
international economic and political conditions, and by governmental monetary
and fiscal policies.  Conditions such as inflation, recession,
unemployment, volatile interest rates, tight money supply, real estate values,
international conflicts and other factors beyond our control may adversely
affect our potential profitability.  Any future rises in interest
rates, while increasing the income yield on our earning assets, may adversely
affect loan demand and the cost of funds and, consequently, our
profitability.  Any future decreases in interest rates may adversely
affect our profitability because such decreases may reduce the amounts that we
may earn on our assets.  Economic downturns have resulted and may
continue to result in the delinquency of outstanding loans.  We do not
expect any one particular factor to materially affect our results of
operations.  However, downtrends in several areas, including real
estate, construction and consumer spending, could have a material adverse impact
on our ability to remain profitable.  Further, there can be no
assurance that the asset values of the loans included in our loan portfolio, or
the value of properties and other collateral securing such loans, will remain at
the levels existing on the dates of origination of such loans.







28





The
changing economic environment poses significant challenges for the
Company.





In 2007
and in 2008, negative developments in the financial services industry have
resulted in uncertainty in the financial markets in general and a related
general economic downturn globally, which have continued into
2009.  In addition, as a consequence of the United States recession,
business activity across a wide range of industries face serious difficulties
due to the decline in the housing market, lack of consumer spending and the
extreme lack of liquidity in the global credit markets. Unemployment has also
increased significantly.




As a
result of these financial economic crises, many lending institutions, including
us, have experienced declines in the performance of their loans, including
construction, land and residential building lots, multi-family, commercial and
consumer loans.  Moreover, competition among depository institutions
for deposits and quality loans has increased significantly while the significant
decline in economic growth has led to a slowdown in banking related
activities.  In addition, the values of real estate collateral
supporting many commercial loans and home mortgages have declined and may
continue to decline.  A worsening of these conditions would likely
exacerbate the adverse effects of these difficult market conditions on us and
others in the financial services industry.




As a
result, there is a potential for new federal or state laws and regulations
regarding lending and funding practices and liquidity standards, and bank
regulatory agencies are expected to be very aggressive in responding to concerns
and trends identified in examinations, including the expected issuance of many
formal or informal enforcement actions or orders. The impact of new legislation
in response to those developments may negatively impact our operations by
restricting our business operations, including our ability to originate or sell
loans, and adversely impact our financial performance or our stock
price.




We are
operating in a challenging economic environment, including generally uncertain
national and local market conditions.  Negative market developments
may affect consumer confidence levels and may cause adverse changes in payment
patterns, causing increases in delinquencies and default rates, which may impact
our charge-offs and provision for credit losses.  Continued declines
in real estate values, home sales volumes and financial stress on borrowers as a
result of the uncertain economic environment, including job losses and other
factors, could have adverse effects on our borrowers, which could adversely
affect our financial condition and results of operations.  For
instance, because payments on loans secured by commercial real estate properties
are often dependent upon the successful operation of management of the
properties, repayment of these loans are subject to adverse conditions in the
economy.  As consumer spending decreases, businesses located in
commercial real estate property may close reducing the rental income of the
Bank’s borrower.  The reduction in rental income may result in the
borrower being unable to make payments on the loan.  The deterioration
in economic conditions could drive losses beyond that which is provided for in
our allowance for loan losses and could result in the following:





·
            an
      increase in loan delinquencies, problem assets and
      foreclosures;




·
            a
      decline in demand for our products and
services;




·
            a
      decrease in low cost or non-interest-bearing deposits;
  and




·
            a
      decline in the value of the collateral for our loans, which in turn may
      reduce customers’ borrowing capacities, and reduce the value of assets and
      collateral supporting our existing
loans.




During
the past year, we have experienced an increase in non-performing
loans.  No assurance can be given that these conditions will improve
in the near term or will not worsen.  Moreover, such conditions may
result in a further increase in loan delinquencies, causing a decrease in our
interest income, and may continue to have an adverse impact on our loan loss
experience, possibly requiring us to add to our allowance for loan
losses.  Until conditions improve, we expect our business, financial
condition and results of operations to be adversely affected.






29





Changes
in interest rates could adversely affect our financial condition and results of
operations.





The
operations of financial institutions, such as ours, are dependent to a large
degree on net interest income, which is the difference between interest income
from loans and investments and interest expense on deposits and borrowings. Our
net interest income is significantly affected by market rates of interest that
in turn are affected by prevailing economic conditions, fiscal and monetary
policies of the federal government and the policies of various regulatory
agencies. Like all financial institutions, our balance sheet is affected by
fluctuations in interest rates. Volatility in interest rates can also result in
disintermediation, which is the flow of funds away from financial institutions
into direct investments, such as U.S. Government bonds, corporate securities and
other investment vehicles, including mutual funds, which, because of the absence
of federal insurance premiums and reserve requirements, generally pay higher
rates of return than those offered by financial institutions such as
ours.





We
believe that, in the current market environment, we have adequate policies and
procedures for maintaining a conservative interest rate sensitive
position.   However, there is no assurance that this condition
will continue.  A sharp movement up or down in deposit rates, loan
rates, investment fund rates and other interest-sensitive instruments on our
balance sheet could have a significant, adverse impact on our net interest
income and operating results.





Most
of our loans are secured by real estate located in our market
area.  If there is a continuing downturn in the real estate market,
additional borrowers may default on their loans and we may not be able to fully
recover our loans.





A
continuing downturn in the real estate market could adversely affect our
business because most of our loans are secured by real
estate.  Substantially all of our real estate collateral is located in
the states of Maryland, Virginia and Delaware.  Real estate values and
real estate markets are generally affected by changes in national, regional or
local economic conditions, fluctuations in interest rates and the availability
of loans to potential purchasers, changes in tax laws and other governmental
statutes, regulations and policies and acts of nature.




In
addition to the risks generally present with respect to mortgage lending
activities, our operations are affected by other factors affecting our
borrowers, including:





·
            the
      ability of our mortgagors to make mortgage
  payments,




·
            the
      ability of our borrowers to attract and retain buyers or tenants, which
      may in turn be affected by local conditions such as an oversupply of space
      or a reduction in demand for rental space in the area, the attractiveness
      of properties to buyers and tenants, and competition from other available
      space, or by the ability of the owner to pay leasing commissions, provide
      adequate maintenance and insurance, pay tenant improvements costs and make
      other tenant concessions,




·
            interest
      rate levels and the availability of credit to refinance loans at or prior
      to maturity, and




·
            increased operating costs,
      including energy costs, real estate taxes and costs of compliance with
      environmental controls and
regulations.







As of
December 31, 2008, approximately 99% of the book value of our loan portfolio
consisted of loans collateralized by various types of real estate.  If
real estate prices decline, the value of real estate collateral securing our
loans will be reduced.   Our ability to recover defaulted loans
by foreclosing and selling the real estate collateral would then be diminished,
and we would be more likely to incur financial losses on defaulted
loans.





In
addition, approximately 55% of the book value of our loans consisted of
construction, land acquisition and development loans, commercial real estate
loans and land loans, which present additional risks described in “Item
1. Business - Construction Loans” of this Form 10-K.







30




Our loan
portfolio exhibits a high degree of risk.





We have a
significant amount of nonresidential loans, as well as construction and land
loans granted on a speculative basis. Although permanent single-family,
owner-occupied loans represent the largest single component of assets and
currently impaired loans, a significant level of nonresidential loans,
construction loans, and land loans, results in an above-average risk
exposure.  Our monitoring of higher risk loans may be inadequate and
the internal asset review function may be inadequate in view of current real
estate market weaknesses.





At
December 31, 2008 and December 31, 2007, our nonperforming loans (those loans 90
or more days in arrears) equaled $54.8 million and $7.7 million, respectively.
There were 118 residential loans in non-accrual status totaling $51.7 million
and eleven commercial loans in non-accrual status totaling $3.1 million at
December 31, 2008 compared to 17 residential loans in non-accrual status
totaling $7.4 million and two commercial loans in non-accrual status totaling
$0.3 million at December 31, 2007. For the year ended December 31, 2008,
there were $3.5 million of loan charge-offs. At December 31, 2008, the
total allowance for loan losses was $14.8 million, which was 1.65% of total net
loans, compared with $10.8 million, which was 1.21% of total net loans, as of
December 31, 2007.





We
are exposed to risk of environmental liabilities with respect to properties to
which it takes title.





In the
course of our business, we may foreclose and take title to real estate, and
could be subject to environmental liabilities with respect to these
properties.  We may be held liable to a governmental entity or to
third parties for property damage, personal injury, investigation and clean-up
costs incurred by these parties in connection with environmental contamination,
or may be required to investigate or clean up hazardous or toxic substances, or
chemical releases at a property.  The costs associated with
investigation or remediation activities could be substantial.  In
addition, if we are the owner or former owner of a contaminated site, we may be
subject to common law claims by third parties based on damages and costs
resulting from environmental contamination emanating from the
property.  If we become subject to significant environmental
liabilities, our business, financial condition, results of operations and cash
flows could be materially and adversely affected.





Our
operations are located in Anne Arundel County, Maryland, which makes our
business highly susceptible to local economic conditions.  An economic
downturn or recession in this area may adversely affect our ability to operate
profitably.





Unlike
larger banking organizations that are geographically diversified, our operations
are concentrated in Anne Arundel County, Maryland.  In addition,
nearly all of our loans have been made to borrowers in the states of Maryland,
Virginia and Delaware.  As a result of this geographic concentration,
our financial results depend largely upon economic conditions in our market
area.  A deterioration or recession in economic conditions in this
market could result in one or more of the following:





·
            a
      decrease in deposits;




·
            an
      increase in loan delinquencies;




·
            an
      increase in problem assets and
foreclosures;




·
            a
      decrease in the demand for our products and services;
  and




·
            a
      decrease in the value of collateral for loans, especially real estate, and
      reduction in customers’ borrowing
capacities.





Any of
the foregoing factors may adversely affect our ability to operate
profitably.





We
are subject to federal and state regulation and the monetary policies of the
FRB.  Such regulation and policies can have a material adverse effect
on our earnings and prospects.





Our
operations are heavily regulated and will be affected by present and future
legislation and by the policies established from time to time by various federal
and state regulatory authorities.  In particular, the monetary
policies of the FRB have had a significant effect on the operating results of
banks in the past, and are expected to continue to do so in the
future.  Among the instruments of monetary policy used by the FRB to
implement its objectives are changes in the discount rate charged on bank
borrowings and changes in the reserve requirements on bank
deposits.  It is not possible to predict what changes, if any, will be
made to the monetary polices of the FRB or to existing federal and state
legislation or the effect that such changes may have on our future business and
earnings prospects.






31






If the
Bank becomes “undercapitalized” as determined under the “prompt corrective
action” initiatives of the federal bank regulators, such regulatory authorities
will have the authority to require the Bank to, among other things, alter,
reduce or terminate any activity that the regulator determines poses an
excessive risk to the Bank.  The Bank could further be directed
to take any other action that the regulatory agency determines will better carry
out the purpose of prompt corrective action. The Bank could be subject to these
prompt corrective action restrictions if federal regulators determine that the
Bank is in an unsafe or unsound condition or engaging in an unsafe or unsound
practice. Some or all of the foregoing actions and restrictions could have a
material adverse effect on our operations.





We
have established an allowance for loan losses based on our management's
estimates.  Actual losses could differ significantly from those
estimates. If the allowance is not adequate, it could have a material adverse
effect on our earnings and the price of our common stock.





We
maintain an allowance for loan losses, which is a reserve established through a
provision for loan losses charged to expense, that represents management's best
estimate of probable incurred losses within the existing portfolio of
loans.  The allowance, in the judgment of management, is necessary to
reserve for estimated loan losses and risks inherent in the loan
portfolio.  The level of the allowance reflects management's
continuing evaluation of specific credit risks; loan loss experience; current
loan portfolio quality; present economic, political and regulatory conditions;
industry concentrations and other unidentified losses inherent in the current
loan portfolio.  The determination of the appropriate level of the
allowance for loan losses inherently involves a high degree of subjectivity and
judgment and requires us to make significant estimates of current credit risks
and future trends, all of which may undergo material changes.  Changes
in economic conditions affecting borrowers, new information regarding existing
loans, identification of additional problem loans and other factors, both within
and outside of our control, may require an increase in the allowance for loan
losses.  Increases in nonperforming loans have a significant impact on
our allowance for loan losses.  Generally, our non-performing loans
and assets reflect operating difficulties of individual borrowers resulting from
weakness in the economy of our market area.  If current trends in the
real estate markets continue, we expect that we will continue to experience
increased delinquencies and credit losses, particularly with respect to
construction, land and residential building lots, multi-family, commercial and
consumer loans.  Moreover, with the country currently in a recession,
we expect that it will negatively impact economic conditions in our market areas
and that we could experience significantly higher delinquencies and credit
losses.





In
addition, bank regulatory agencies periodically review our allowance for loan
losses and may require an increase in the provision for loan losses or the
recognition of further loan charge-offs, based on judgments different than those
of management.  If charge-offs in future periods exceed the allowance
for loan losses, we will need additional provisions to increase the allowance
for loan losses.  Furthermore, growth in the loan portfolio would
generally lead to an increase in the provision for loan losses.





Any
increases in the allowance for loan losses will result in a decrease in net
income and capital, and may have a material adverse effect on our financial
condition, results of operations and cash flows.





We
compete with a number of local, regional and national financial institutions for
customers.





We face
strong competition from savings and loan associations, banks, and other
financial institutions that have branch offices or otherwise operate in our
market area, as well as many other companies now offering a range of financial
services. Many of these competitors have substantially greater financial
resources and larger branch systems than us. In addition, many of our
competitors have higher legal lending limits than us.  Particularly
intense competition exists for sources of funds including savings and retail
time deposits as well as for loans and other services offered by
us.  In addition, over the last several years, the banking industry
has undergone substantial consolidation, and this trend is expected to
continue.  Significant ongoing consolidation in the banking industry
may result in one or more large competitors emerging in our primary target
market.  The financial resources, human capital and expertise of one
or more large institutions could threaten our ability to maintain our
competitiveness.






32






During
the past several years, significant legislative attention has been focused on
the regulation and deregulation of the financial services
industry.  Non-bank financial institutions, such as securities
brokerage firms, insurance companies and mutual funds, have been permitted to
engage in activities that compete directly with traditional bank
business.  Competition with various financial institutions could
hinder our ability to maintain profitable operations and grow our
business.





We
face intense competitive pressure on customer pricing, which may materially and
adversely affect revenues and profitability.





We
generate net interest income, and charge our customers fees, based on prevailing
market conditions for deposits, loans and other financial
services.  In order to increase deposit, loan and other service
volumes, enter new market segments and expand our base of customers and the size
of individual relationships, we must provide competitive pricing for such
products and services.  In order to stay competitive, we have had to
intensify our efforts around attractively pricing our products and
services.  To the extent that we must continue to adjust our pricing
to stay competitive, we will need to grow our volumes and balances in order to
offset the effects of declining net interest income and fee-based
margins.  Increased pricing pressure also enhances the importance of
cost containment and productivity initiatives, and we may not succeed in these
efforts.





Our
brand, reputation and relationship with our customers are key assets of our
business and may be affected by how we are perceived in the
marketplace.





Our brand
and its attributes are key assets of our business.  The ability to
attract and retain customers to our Company’s products and services is highly
dependent upon the external perceptions of us and the industry in which we
operate.  Our business may be affected by actions taken by
competitors, customers, third party providers, employees, regulators, suppliers
or others that impact the perception of the brand, such as creditor practices
that may be viewed as “predatory,” customer service quality issues, and employee
relations issues.  Adverse developments with respect to our industry
may also, by association, impair our reputation, or result in greater regulatory
or legislative scrutiny.





If
our information systems or those of our third party providers experience an
interruption or breach in security, our revenues and operating results and the
perception of our brand could be materially and adversely affected.





We rely
heavily on communications and information systems to conduct our
business.  Any failure, interruption or breach in security of these
systems could result in failures or disruptions in our customer relationship
management, general ledger, deposit, loan and other systems.  In
addition, we operate a number of money transfer and related electronic, check
and other payment connections that are vulnerable to individuals engaging in
fraudulent activities that seek to compromise payments and related financial
systems illegally.  While we have policies and procedures designed to
prevent or limit the effect of the failure, interruption or security breach of
our information systems, there can be no assurance that failures, interruptions
or security breaches will not occur or, if they do occur, that they will be
adequately addressed.  The occurrence of any failures, interruptions or
security breaches of our information systems could damage our reputation, result
in a loss of customer business, subject us to additional regulatory scrutiny, or
expose us to civil litigation and possible financial liability, any of which
could have a material adverse effect on our financial condition and results of
operations.  We depend on third-party providers for many of our
systems and if these providers experience financial, operational or
technological difficulties, or if there is any other disruption in our
relationships with them, we may be required to locate alternative sources of
such services, and we cannot assure you that we would be able to negotiate terms
that are as favorable to us, or could obtain services with similar functionality
as found in our existing systems without the need to expend substantial
resources, if at all.







33






We
continually encounter technological change, and, if we are unable to develop and
implement efficient and customer friendly technology, we could lose
business.





The
financial services industry is continually undergoing rapid technological
change, with frequent introductions of new technology-driven products and
services.  The effective use of technology increases efficiency and
enables financial institutions to better serve customers and to reduce
costs.  Our future success depends, in part, upon our ability to
address the needs of our customers by using technology to provide products and
services that will satisfy customer demands, as well as to achieve additional
efficiencies in our operations.  Many of our competitors have
substantially greater resources to invest in technological
improvements.  We may not be able to effectively implement new
technology-driven products and services or be successful in marketing these
products and services to our customers.  Failure to successfully keep
pace with technological change affecting the financial services industry could
have a material adverse impact on our business and, in turn, our financial
condition and results of operations.





Our
success depends on our senior management team, and if we are not able to retain
our senior management team, it could have a material adverse effect on
us.





We are
highly dependent upon the continued services and experience of our senior
management team, including Alan J. Hyatt, our Chairman, President and Chief
Executive Officer. We depend on the services of Mr. Hyatt and the other members
of our senior management team to, among other things, continue the development
and implementation of our strategies, and maintain and develop our customer
relationships.  We do not have an employment agreement with members of
our senior management, nor do we maintain “key-man” life insurance on our senior
management.  If we are unable to retain Mr. Hyatt and other
members of our senior management team, our business could be materially and
adversely affected.





If
we fail to maintain an effective system of internal control over financial
reporting and disclosure controls and procedures, we may be unable to accurately
report our financial results and comply with the reporting requirements under
the Securities Exchange Act of 1934.  As a result, current and
potential stockholders may lose confidence in our financial reporting and
disclosure required under the Securities Exchange Act of 1934, which could
adversely affect our business and could subject us to regulatory
scrutiny.





Pursuant
to Section 404 of the Sarbanes-Oxley Act of 2002, referred to as Section 404, we
are required to include in our Annual Reports on Form 10-K, our management’s
report on internal control over financial reporting.  While we have
reported no “significant deficiencies” or “material weaknesses” in the Form 10-K
for the fiscal year ended December 31, 2008, we cannot guarantee that we will
not have any “significant deficiencies” or “material weaknesses” reported by our
independent registered public accounting firm in the future. Compliance with the
requirements of Section 404 is expensive and time-consuming. If, in the future,
we fail to complete this evaluation in a timely manner, or if our independent
registered public accounting firm cannot timely attest to our evaluation, we
could be subject to regulatory scrutiny and a loss of public confidence in our
internal control over financial reporting.  In addition, any failure
to establish an effective system of disclosure controls and procedures could
cause our current and potential stockholders and customers to lose confidence in
our financial reporting and disclosure required under the Securities Exchange
Act of 1934, which could adversely affect our business.





Terrorist
attacks and threats or actual war may impact all aspects of our operations,
revenues, costs and stock price in unpredictable ways.




Terrorist
attacks in the United States and abroad, as well as future events occurring in
response to or in connection with them, including, without limitation, future
terrorist attacks against U.S. targets, rumors or threats of war, actual
conflicts involving the United States or its allies or military or trade
disruptions, may impact our operations.  Any of these events could
cause consumer confidence and savings to decrease or could result in increased
volatility in the United States and worldwide financial markets and
economy.  Any of these occurrences could have an adverse impact on our
operating results, revenues and costs and may result in the volatility of the
market price for our common stock and on the future price of our common
stock.






34






Our
Series A preferred stock, Series B preferred stock and 2035 Debentures contain
restrictions on our ability to declare and pay dividends on, or repurchase, our
common stock.





Our
ability to declare dividends on our common stock is limited by the terms of our
Series A preferred stock and Series B preferred stock.  We may not
declare or pay any dividend on, make any distributions relating to, or redeem,
purchase, acquire or make a liquidation payment relating to, or make any
guarantee payment with respect to our common stock in any quarter until the
dividend on the Series A Preferred Stock has been declared and paid for such
quarter, subject to certain minor exceptions.  Additionally, prior to
November 21, 2011, unless we have redeemed the Series B preferred stock or the
Treasury Department has transferred the Series B preferred stock to a third
party, we may not, without the consent of the Treasury (1) declare or pay any
dividend or make any distribution on our common stock (other than regular
quarterly cash dividends of not more than $0.06 per share) or (2) redeem,
purchase or acquire any shares of our common stock or other equity or capital
securities, other than in connection with benefit plans consistent with past
practice and certain other circumstances specified in the Letter Agreement with
the Treasury Department.





Additionally,
under the terms of our 2035 Debentures, if (i) there has occurred and is
continuing an event of default, (ii) we are in default with respect to payment
of any obligations under the related guarantee or (iii) we have given notice of
our election to defer payments of interest on the 2035 Debentures by extending
the interest distribution period as provided in the indenture governing the 2035
Debentures and such period, or any extension thereof, has commenced and is
continuing, then we may not, among other things, declare or pay any dividends or
distributions on, or redeem, purchase, acquire, or make a liquidation payment
with respect to, any of our capital stock, including our common
stock.





There
can be no assurance that we will continue to pay dividends in the
future.





Although
we expect to continue our policy of quarterly dividend payments, this dividend
policy will be reviewed periodically in light of future earnings, regulatory
restrictions and other considerations.  No assurance can be given,
therefore, that cash dividends on our common stock will be paid in the
future.





An
investment in our securities is not insured against loss.





Investments
in our common stock, are not deposits insured against loss by the FDIC or any
other entity.  As a result, an investor may lose some or all of his,
her or its investment.





Conversion
of our Series A preferred stock or exercise of the warrant issued to the
Treasury Department will dilute the ownership interest of existing
stockholders.





In
private placements conducted in November 2008, we issued Series A preferred
stock convertible into 437,500 shares of our common stock, subject to
adjustment, and a warrant to purchase 556,976 shares of our common stock,
subject to adjustment.  The conversion of some or all of the Series A
preferred stock or the exercise of the warrant will dilute the ownership
interest of existing stockholders. Any sales in the public market of the common
stock issuable upon such conversion or exercise could adversely affect
prevailing market prices of our common stock. In addition, the existence of the
Series A preferred stock or warrant may encourage short selling by market
participants because the conversion of the Series A preferred stock or exercise
of the warrant could depress the price of our common stock.





“Anti-takeover”
provisions will make it more difficult for a third party to acquire control of
us, even if the change in control would be beneficial to our equity
holders.





Our
charter presently contains certain provisions that may be deemed to be
“anti-takeover” and “anti-greenmail” in nature in that such provisions may
deter, discourage or make more difficult the assumption of control of us by
another corporation or person through a tender offer, merger, proxy contest or
similar transaction or series of transactions.  For example,
currently, our charter provides that our Board of Directors may amend the
charter, without stockholder approval, to increase or decrease the aggregate
number of shares of our stock or the number of shares of any class that we have
authority to issue.  In addition, our charter provides for a
classified Board, with each Board member serving a staggered three-year
term.  Directors may be removed only for cause and only with the
approval of the holders of at least 75 percent of our common
stock.  The overall effects of the “anti-takeover” and
“anti-greenmail” provisions may be to discourage, make more costly or more
difficult, or prevent a future takeover offer, prevent stockholders from
receiving a premium for their securities in a takeover offer, and enhance the
possibility that a future bidder for control of us will be required to act
through arms-length negotiation with our Board of Directors.  These
provisions may also have the effect of perpetuating incumbent
management.






35






Item
1B.  Unresolved Staff Comments





None





Item
2.  Properties





HS constructed a building in Annapolis,
Maryland that serves as Bancorp’s and the Bank’s administrative headquarters. A
branch office of the Bank is also included in the building.  Bancorp
and the Bank lease their executive and administrative offices from
HS.  In addition, HS leases space to four unrelated companies and to a
law firm in which the President of Bancorp and the Bank is a
partner.





Bancorp has four retail branch
locations in Anne Arundel County, Maryland, of which it owns three and leases
the fourth from a third party.  The lease expires July 2010, with the
option to renew the lease for two additional five year terms.  In
addition, the Bank leases office space in Annapolis, Maryland from a third
party.  The lease expires January 2010, with the option to renew the
lease for two additional five year terms.





Item 3.  Legal
Proceedings





There are no material pending legal
proceedings to which Bancorp, the Bank or any subsidiary is a party or to which
any of their property is subject.





Item
4.  Submission of Matters to a Vote of Security
Holders





None.





Item
4.1.  Executive Officers of the Registrant that are not
Directors





Thomas G. Bevivino, age 53, joined
Bancorp in August 2004 as Controller, and has served as the Chief Financial
Officer since July 1, 2005.  He serves in the same capacity for the
Bank.  Mr. Bevivino was a financial consultant from 2002 until 2004,
and served as Chief Financial Officer of Luminant Worldwide Corporation from
1999 until 2002.




36





PART II





Item 5.  Market
for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities





The common stock of Bancorp is traded
on the Nasdaq Capital Market under the symbol “SVBI”.  As of March 3,
2009, there were 1,510 stockholders of record of Bancorp’s common
stock.





Registrar and Transfer Company, 10
Commerce Drive, Cranford, New Jersey 07016-3572, serves as the Transfer Agent
and Registrar for Bancorp.





The following table sets forth the
high and low sales prices per share of Bancorp’s common stock for the periods
indicated, as reported on the Nasdaq Capital Market:





Quarterly
Stock Information*





2008
                  
                  2007Stock
      Price Range
                  
                  
                  Per
      Share
                  
                  
                  
                  Stock
      Price Range
                  
                  
                  Per
      ShareQuarter
                  
                  Low
                  
                  
                  High
                  
                  
                  Dividend
                  
                  Quarter
                  
                  Low
                  
                  
                  High
                  
                  
                  Dividend1st
                  
                  $
                  7.80
                  
                  
                  $
                  12.00
                  
                  
                  $
                  .060
                  
                  1st
                  
                  $
                  16.78
                  
                  
                  $
                  22.55
                  
                  
                  $
                  .0602nd
                  
                  
                  6.52
                  
                  
                  
                  9.45
                  
                  
                  
                  .060
                  
                  2nd
                  
                  
                  16.24
                  
                  
                  
                  20.23
                  
                  
                  
                  .0603rd
                  
                  
                  5.50
                  
                  
                  
                  6.99
                  
                  
                  
                  .060
                  
                  3rd
                  
                  
                  12.25
                  
                  
                  
                  17.00
                  
                  
                  
                  .0604th
                  
                  
                  3.70
                  
                  
                  
                  6.54
                  
                  
                  
                  .060
                  
                  4th
                  
                  
                  8.21
                  
                  
                  
                  13.28
                  
                  
                  
                  .060





*Retroactively adjusted to reflect a
10% stock dividend declared February 20, 2007 effective for shares outstanding
March 15, 2007.





Dividend
Policy





Bancorp’s
main source of income is dividends from the Bank.  As a result,
Bancorp's dividends to its shareholders will depend primarily upon receipt of
dividends from the Bank.





OTS
regulations limit the payment of dividends and other capital distributions by
the Bank. The Bank is required to obtain OTS approval if the total amount of the
Bank’s capital distribution (including the proposed dividend) for the current
year exceeds net income for that year to date plus the Bank’s retained net
income for the preceding two years.  Additionally, the Bank may not
pay dividends on its stock in an amount that would reduce its capital levels
below its regulatory capital requirements.  For further information,
see Note 12 to the consolidated financial statements and “Item 1. Business
Regulation – Regulation of the Bank – Capital Distribution
Limitations.”





Bancorp’s
ability to declare dividends on its common stock is limited by the terms of
Bancorp’s Series A preferred stock and Series B preferred
stock.  Bancorp may not declare or pay any dividend on, make any
distributions relating to, or redeem, purchase, acquire or make a liquidation
payment relating to, or make any guarantee payment with respect to its common
stock in any quarter until the dividend on the Series A Preferred Stock has been
declared and paid for such quarter, subject to certain minor
exceptions.  Additionally, prior to November 21, 2011, unless Bancorp
has redeemed the Series B preferred stock or the Treasury Department has
transferred the Series B preferred stock to a third party,  Bancorp
may not, without the consent of the Treasury (1) declare or pay any dividend or
make any distribution on its common stock (other than regular quarterly cash
dividends of not more than $0.06 per share) or (2) redeem, purchase or acquire
any shares of our common stock or other equity or capital securities, other than
in connection with benefit plans consistent with past practice and certain other
circumstances specified in the Letter Agreement with the Treasury
Department.







37






Additionally,
under the terms of Bancorp's 2035 Debentures, if (i) there has occurred and is
continuing an event of default, (ii) Bancorp is in default with respect to
payment of any obligations under the related guarantee or (iii) Bancorp has
given notice of its election to defer payments of interest on the 2035
Debentures by extending the interest distribution period as provided in the
indenture governing the 2035 Debentures and such period, or any extension
thereof, has commenced and is continuing, then Bancorp may not, among other
things, declare or pay any dividends or distributions on, or redeem, purchase,
acquire, or make a liquidation payment with respect to, any of its capital
stock, including common stock.























































38


Stock Performance
Graph





The graph
below sets forth comparative information regarding the Company’s cumulative
shareholder return on its Common Stock over the last five years. Total
shareholder return is measured by dividing total dividends (assuming dividend
reinvestment) for the measurement period plus share price change for a period by
the share price at the beginning of the measurement period. Severn Bancorp, Inc.'s cumulative
shareholder return is based on an investment of $100 on December 31, 2003, and
is compared to the cumulative total return of the NASDAQ Composite Index and the
SNL Securities LC Thrift Index for thrifts with total assets between $500
million and $1.0 billion (the "SNL Thrift ($500M to $1.0B)
Index")





Comparison
of Cumulative Total Return Among Severn, NASDAQ Composite Index


and
SNL Thrift ($500M to $1.0B) Index from December 31, 2003 to  December
31, 2008





Severn
      Bancorp, Inc.











Period
      EndingIndex
                12/31/03
                12/31/04
                12/31/05
                12/31/06
                12/31/07
                12/31/08Severn
      Bancorp, Inc.
                100.00
                152.76
                124.80
                137.39
                77.56
                35.49NASDAQ
      Composite Index
                100.00
                108.59
                110.08
                120.56
                132.39
                78.72SNL
      $500M-$1B Thrift Index
                100.00
                110.61
                105.12
                128.81
                101.83
                75.51





See Item
12 in Part III of this Annual Report on Form 10-K and Notes 9 and 11 to the
consolidated financial statements for information regarding equity compensation
plans.













39


Item 6.  Selected
Financial Data








For information concerning quarterly
financial data for Bancorp, see Note 17 to the consolidated financial
statements.





The following financial information
is derived from the audited financial statements of Bancorp.  The
information is a summary and should be read in conjunction with Bancorp’s
audited financial statements and Management’s Discussion and Analysis of
Financial Condition and Results of Operations.





Summary Financial and Other
Data





At
      December 31,2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004(dollars
      in thousands, except per share information)Balance
      Sheet DataTotal
      assets
                    
                    $
                    987,651
                    
                    
                    $
                    962,234
                    
                    
                    $
                    911,916
                    
                    
                    $
                    849,774
                    
                    
                    $
                    703,616Total
      loans, net
                    
                    
                    896,459
                    
                    
                    
                    893,014
                    
                    
                    
                    835,477
                    
                    
                    
                    779,333
                    
                    
                    
                    656,967Investment
      securities held to maturity
                    
                    
                    1,345
                    
                    
                    
                    2,383
                    
                    
                    
                    7,271
                    
                    
                    
                    8,290
                    
                    
                    
                    9,955Non-performing
      loans
                    
                    
                    54,795
                    
                    
                    
                    7,700
                    
                    
                    
                    5,927
                    
                    
                    
                    1,693
                    
                    
                    
                    939Total
      non-performing assets
                    
                    
                    61,112
                    
                    
                    
                    10,693
                    
                    
                    
                    6,897
                    
                    
                    
                    1,693
                    
                    
                    
                    939Deposits
                    
                    
                    683,866
                    
                    
                    
                    652,773
                    
                    
                    
                    626,524
                    
                    
                    
                    594,893
                    
                    
                    
                    527,413Short-term
      borrowings
                    
                    
                    -
                    
                    
                    
                    15,000
                    
                    
                    
                    18,000
                    
                    
                    
                    26,000
                    
                    
                    
                    -Long-term
      debt
                    
                    
                    153,000
                    
                    
                    
                    175,000
                    
                    
                    
                    155,000
                    
                    
                    
                    132,000
                    
                    
                    
                    89,000Total
      liabilities
                    
                    
                    863,984
                    
                    
                    
                    866,958
                    
                    
                    
                    825,474
                    
                    
                    
                    777,062
                    
                    
                    
                    639,462Stockholders’
      equity
                    
                    
                    123,667
                    
                    
                    
                    95,276
                    
                    
                    
                    86,442
                    
                    
                    
                    72,712
                    
                    
                    
                    60,154Book
      value per common share *
                    
                    $
                    9.64
                    
                    
                    $
                    9.46
                    
                    
                    $
                    8.59
                    
                    
                    $
                    7.23
                    
                    
                    $
                    5.97Common
      shares outstanding *
                    
                    
                    10,066,679
                    
                    
                    
                    10,066,679
                    
                    
                    
                    10,065,935
                    
                    
                    
                    10,065,002
                    
                    
                    
                    10,065,002Other
      Data:Number
      of:Full
      service retail banking facilities
                    
                    
                    4
                    
                    
                    
                    4
                    
                    
                    
                    3
                    
                    
                    
                    3
                    
                    
                    
                    3Full-time
      equivalent employees
                    
                    
                    106
                    
                    
                    
                    118
                    
                    
                    
                    121
                    
                    
                    
                    111
                    
                    
                    
                    105*
      Retroactively adjusted to reflect a 10% stock dividend declared February
      20, 2007 and a 10% stock dividend declared February 21,
    2006.





40





Summary of
Operations


For
      the Year Ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006
                          
                          
                          2005
                          
                          
                          2004(dollars
      in thousands, except per share information)Interest
      income
                          
                          $
                          62,472
                          
                          
                          $
                          71,814
                          
                          
                          $
                          70,175
                          
                          
                          $
                          57,135
                          
                          
                          $
                          44,829Interest
      expense
                          
                          
                          33,503
                          
                          
                          
                          38,176
                          
                          
                          
                          32,060
                          
                          
                          
                          21,955
                          
                          
                          
                          14,631Net
      interest income
                          
                          
                          28,969
                          
                          
                          
                          33,638
                          
                          
                          
                          38,115
                          
                          
                          
                          35,180
                          
                          
                          
                          30,198Provision
      for loan losses
                          
                          
                          7,481
                          
                          
                          
                          2,462
                          
                          
                          
                          1,561
                          
                          
                          
                          1,570
                          
                          
                          
                          1,200Net
      interest income after provision for loan losses
                          
                          
                          21,488
                          
                          
                          
                          31,176
                          
                          
                          
                          36,554
                          
                          
                          
                          33,610
                          
                          
                          
                          28,998Non-interest
      income
                          
                          
                          2,791
                          
                          
                          
                          4,336
                          
                          
                          
                          3,867
                          
                          
                          
                          2,748
                          
                          
                          
                          3,402Non-interest
      expense
                          
                          
                          17,293
                          
                          
                          
                          16,492
                          
                          
                          
                          14,065
                          
                          
                          
                          12,878
                          
                          
                          
                          11,211Income
      before income tax provision
                          
                          
                          6,986
                          
                          
                          
                          19,020
                          
                          
                          
                          26,356
                          
                          
                          
                          23,480
                          
                          
                          
                          21,189Provision
      for income taxes
                          
                          
                          2,873
                          
                          
                          
                          7,909
                          
                          
                          
                          10,608
                          
                          
                          
                          8,926
                          
                          
                          
                          8,258Net
      income
                          
                          $
                          4,113
                          
                          
                          $
                          11,111
                          
                          
                          $
                          15,748
                          
                          
                          $
                          14,554
                          
                          
                          $
                          12,931Per
      Share Data:Basic
      earnings per share *
                          
                          $
                          0.39
                          
                          
                          $
                          1.10
                          
                          
                          $
                          1.56
                          
                          
                          $
                          1.45
                          
                          
                          $
                          1.29Diluted
      earnings per share *
                          
                          $
                          0.39
                          
                          
                          $
                          1.10
                          
                          
                          $
                          1.56
                          
                          
                          $
                          1.45
                          
                          
                          $
                          1.29Cash
      dividends declared per share*
                          
                          $
                          .24
                          
                          
                          $
                          .24
                          
                          
                          $
                          .22
                          
                          
                          $
                          .20
                          
                          
                          $
                          .17Weighted
      number of shares outstanding basic *
                          
                          
                          10,066,679
                          
                          
                          
                          10,066,283
                          
                          
                          
                          10,065,289
                          
                          
                          
                          10,065,002
                          
                          
                          
                          10,065,002Weighted
      number of shares outstanding diluted *
                          
                          
                          10,066,679
                          
                          
                          
                          10,066,283
                          
                          
                          
                          10,069,056
                          
                          
                          
                          10,065,002
                          
                          
                          
                          10,065,002


*
      Retroactively adjusted to reflect a 10% stock dividend declared February
      20, 2007 and a 10% stock dividend declared February 21,
    2006.















41




Key Operating
Ratios





For
      the Year Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004Performance
      Ratios:Return
      on average assets
                    
                    
                    0.43
                    %
                    
                    
                    1.19
                    %
                    
                    
                    1.77
                    %
                    
                    
                    1.84
                    %
                    
                    
                    2.02
                    %Return
      on average equity
                    
                    
                    4.03
                    %
                    
                    
                    12.09
                    %
                    
                    
                    19.59
                    %
                    
                    
                    21.85
                    %
                    
                    
                    23.56
                    %Dividend
      payout ratio
                    
                    
                    61.54
                    %
                    
                    
                    21.82
                    %
                    
                    
                    13.95
                    %
                    
                    
                    13.84
                    %
                    
                    
                    13.38
                    %Net
      interest margin
                    
                    
                    3.16
                    %
                    
                    
                    3.81
                    %
                    
                    
                    4.50
                    %
                    
                    
                    4.58
                    %
                    
                    
                    4.81
                    %Interest
      rate spread
                    
                    
                    2.81
                    %
                    
                    
                    3.45
                    %
                    
                    
                    4.20
                    %
                    
                    
                    4.32
                    %
                    
                    
                    4.60
                    %Non-interest
      expense to average assets
                    
                    
                    1.79
                    %
                    
                    
                    1.76
                    %
                    
                    
                    1.58
                    %
                    
                    
                    1.63
                    %
                    
                    
                    1.75
                    %Efficiency
      ratio
                    
                    
                    54.45
                    %
                    
                    
                    43.43
                    %
                    
                    
                    33.50
                    %
                    
                    
                    33.95
                    %
                    
                    
                    33.37
                    %Asset
      Quality Ratios:Average
      equity to average assets
                    
                    
                    10.55
                    %
                    
                    
                    9.82
                    %
                    
                    
                    9.02
                    %
                    
                    
                    8.42
                    %
                    
                    
                    8.57
                    %Nonperforming
      assets to total assetsat
      end of period
                    
                    
                    6.19
                    %
                    
                    
                    1.11
                    %
                    
                    
                    0.76
                    %
                    
                    
                    0.20
                    %
                    
                    
                    0.13
                    %Nonperforming
      loans to total grossloans
      at end of period
                    
                    
                    5.63
                    %
                    
                    
                    0.78
                    %
                    
                    
                    0.62
                    %
                    
                    
                    0.18
                    %
                    
                    
                    0.12
                    %Allowance
      for loan losses tonet
      loans at end of period
                    
                    
                    1.65
                    %
                    
                    
                    1.21
                    %
                    
                    
                    1.08
                    %
                    
                    
                    0.96
                    %
                    
                    
                    0.90
                    %Allowance
      for loan losses tononperforming
      loans at end of period
                    
                    
                    27.03
                    %
                    
                    
                    140.01
                    %
                    
                    
                    152.29
                    %
                    
                    
                    443.30
                    %
                    
                    
                    632.10
                    %





42


Average Balance
Sheet


Average
Balance Sheet.  The following table contains for the periods indicated
information regarding the total dollar amounts of interest income from
interest-earning assets and the resulting average yields, the total dollar
amount of interest expense on interest-bearing liabilities and the resulting
average costs, net interest income, and the net yield on interest-earning
assets.




Year
      Ended December 31,2008
                    
                    2007
                    
                    2006Average
                    
                    
                    
                    Average
                    
                    
                    
                    AverageVolume
                    Interest
                    Yield/Cost
                    
                    Volume
                    Interest
                    Yield/Cost
                    
                    Volume
                    Interest
                    Yield/Cost(dollars
      in thousands)ASSETSLoans
      (1)
                    
                    $893,030
                    $61,703
                    6.91%
                    
                    $858,305
                    $70,275
                    8.19%
                    
                    $819,038
                    $68,610
                    8.38%Investments
      (2)
                    
                    -
                    -
                    -
                    
                    3,333
                    121
                    3.63%
                    
                    5,000
                    154
                    3.08%Mortgage-backed
      securities
                    
                    1,363
                    74
                    5.43%
                    
                    1,957
                    96
                    4.91%
                    
                    2,823
                    112
                    3.97%Other
      interest-earning assets (3)
                    
                    23,063
                    695
                    3.01%
                    
                    20,357
                    1,322
                    6.49%
                    
                    19,886
                    1,299
                    6.53%Total
      interest-earning assets
                    
                    917,456
                    62,472
                    6.81%
                    
                    883,952
                    71,814
                    8.12%
                    
                    846,747
                    70,175
                    8.29%Non-interest
      earning assets
                    
                    49,959
                    
                    
                    
                    51,317
                    
                    
                    
                    44,385Total
      Assets
                    
                    $967,415
                    
                    
                    
                    $935,269
                    
                    
                    
                    $891,132LIABILITIES
      AND STOCKHOLDERS' EQUITYSavings
      and checking deposits
                    
                    $119,159
                    $2,018
                    1.69%
                    
                    $132,604
                    $3,272
                    2.47%
                    
                    $138,242
                    $2,728
                    1.97%Certificates
      of deposits
                    
                    552,689
                    23,932
                    4.33%
                    
                    514,523
                    26,075
                    5.07%
                    
                    483,524
                    20,977
                    4.34%Borrowings
                    
                    166,250
                    7,553
                    4.54%
                    
                    170,417
                    8,829
                    5.18%
                    
                    162,417
                    8,355
                    5.14%Total
      interest-bearing liabilities
                    
                    838,098
                    33,503
                    4.00%
                    
                    817,544
                    38,176
                    4.67%
                    
                    784,183
                    32,060
                    4.09%Non-interest
      bearing liabilities
                    
                    27,234
                    
                    
                    
                    25,836
                    
                    
                    
                    26,556Stockholders'
      equity
                    
                    102,083
                    
                    
                    
                    91,889
                    
                    
                    
                    80,393Total
      liabilities and stockholders' equity
                    
                    $967,415
                    
                    
                    
                    $935,269
                    
                    
                    
                    $891,132Net
      interest income and Interest rate spread
                    
                    
                    $28,969
                    2.81%
                    
                    
                    $33,638
                    3.45%
                    
                    
                    $38,115
                    4.20%Net
      interest margin
                    
                    
                    
                    3.16%
                    
                    
                    
                    3.81%
                    
                    
                    
                    4.50%Average
      interest-earning assets toaverage
      interest-bearing liabilities
                    
                    
                    
                    109.47%
                    
                    
                    
                    108.12%
                    
                    
                    
                    107.98%(1)
      Non-accrual loans are included in the average balances and in the
      computation of yields.(2)
      Bancorp does not have any tax-exempt securities.(3)
      Other interest earning assets include interest bearing deposits in other
      banks, federal funds, and FHLB stock investments.





43


Rate Volume
Table


Year
      ended December 31, 2008
                        
                        
                        Year
      ended December 31, 2007vs.
                        
                        
                        vs.Year
      ended December 31, 2007
                        
                        
                        Year
      ended December 31, 2006Total
                        
                        
                        Changes
      Due to
                        
                        
                        Total
                        
                        
                        Changes
      Due toChange
                        
                        
                        Volume
      (1)
                        
                        
                        Rate
      (1)
                        
                        
                        Change
                        
                        
                        Volume
      (1)
                        
                        
                        Rate
      (1)(dollars
      in thousands)Interest-earning
      assetsLoans
                        
                        $
                        (8,572
                        )
                        
                        $
                        2,843
                        
                        
                        $
                        (11,415
                        )
                        
                        $
                        1,665
                        
                        
                        $
                        3,289
                        
                        
                        $
                        (1,624
                        )Investments
                        
                        
                        (121
                        )
                        
                        
                        (121
                        )
                        
                        
                        -
                        
                        
                        
                        (33
                        )
                        
                        
                        (51
                        )
                        
                        
                        18Mortgage-backed
      securities
                        
                        
                        (22
                        )
                        
                        
                        (29
                        )
                        
                        
                        7
                        
                        
                        
                        (16
                        )
                        
                        
                        (34
                        )
                        
                        
                        18Other
      interest-earning assets
                        
                        
                        (627
                        )
                        
                        
                        176
                        
                        
                        
                        (803
                        )
                        
                        
                        23
                        
                        
                        
                        31
                        
                        
                        
                        (8
                        )Total
      interest income
                        
                        $
                        (9,342
                        )
                        
                        $
                        2,869
                        
                        
                        $
                        (12,211
                        )
                        
                        $
                        1,639
                        
                        
                        $
                        3,235
                        
                        
                        $
                        (1,596
                        )Interest-bearing
      liabilitiesSavings
      and checking deposits
                        
                        $
                        (1,254
                        )
                        
                        $
                        (332
                        )
                        
                        $
                        (922
                        )
                        
                        $
                        544
                        
                        
                        $
                        (111
                        )
                        
                        $
                        655Certificates
      of deposits
                        
                        
                        (2,143
                        )
                        
                        
                        1,934
                        
                        
                        
                        (4,077
                        )
                        
                        
                        5,098
                        
                        
                        
                        1,345
                        
                        
                        
                        3,753Borrowings
                        
                        
                        (1,276
                        )
                        
                        
                        (216
                        )
                        
                        
                        (1,060
                        )
                        
                        
                        474
                        
                        
                        
                        412
                        
                        
                        
                        62Total
      interest expense
                        
                        $
                        (4,673
                        )
                        
                        $
                        1,386
                        
                        
                        $
                        (6,059
                        )
                        
                        $
                        6,116
                        
                        
                        $
                        1,646
                        
                        
                        $
                        4,470Net
      change in net interest income
                        
                        $
                        (4,669
                        )
                        
                        $
                        1,483
                        
                        
                        $
                        (6,152
                        )
                        
                        $
                        (4,477
                        )
                        
                        $
                        1,589
                        
                        
                        $
                        (6,066
                        )(1) Changes
      in interest income/expense not arising from volume or rate variances are
      allocated proportionately to rate and volume.







Item
7.  Management's Discussion and Analysis of Financial Condition and
Results of Operations





Overview





Bancorp provides a wide range of
retail and commercial banking services. Deposit services include checking,
individual retirement accounts, money market, savings and time deposit accounts.
Loan services include various types of commercial, consumer, and real estate
lending. The Company also provides ATMs, corporate cash management services,
debit cards, Internet banking including on-line bill pay, mortgage lending, safe
deposit boxes, and telephone banking, among other products and
services.





Bancorp continues to experience
challenges similarly faced by many financial institutions resulting from the
slowdown in the real estate markets, including increased loan delinquencies and
a decrease in the demand for certain loan products including construction,
development, and land acquisition loans. Continued declines in real estate
values, home sales volumes and financial stress on borrowers as a result of the
uncertain economic environment, including job losses and other factors, have
adversely affected Bancorp’s borrowers. This economic deterioration has caused
loan delinquencies and impaired loans to increase. In addition, strong
competition for new loans and deposits has caused the interest rate spread
between the Company’s cost of funds and what it earns on loans to decrease from
2007 levels.  This was primarily due to an increase in non-accrual
loans, and to decreases in interest rates earned on loans outpacing the
decreases in interest paid on deposits and other borrowings.





Even though Bancorp’s total loan
portfolio has increased from 2007, the decrease in the interest rate spread has
caused net interest income to decrease from 2007.  In addition,
Bancorp has experienced an increase in loan delinquencies, which resulted in the
allowance for loan losses to increase from 2007.  The decrease in net
interest income and the increase in the allowance for loan losses, coupled with
increased costs relating to foreclosures have caused Bancorp’s overall
profitability to decrease from 2007.







44




The Company expects to
experience continued difficult market conditions in 2009 as it seeks to grow its
loan portfolio in a difficult market environment.  If interest rates
increase, there may be less demand for borrowing and, the Company’s interest
rate spread could decrease. The Company will continue to manage loan and deposit
pricing against the risks of rising costs of its deposits and borrowings.
Interest rates are outside the control of Bancorp, so it must attempt to balance
its pricing and duration of its loan portfolio against the risks of rising costs
of its deposits and borrowings.





The continued success and attraction
of Anne Arundel County, Maryland, and vicinity, will also be important to
Bancorp’s ability to originate and grow its mortgage loans and deposits, as will
Bancorp’s continued focus on maintaining a low overhead.





In
November 2008, Bancorp completed two private placements:





·
            the
      sale to certain accredited investors of Bancorp's Series A Preferred Stock
      and Subordinated Notes for gross proceeds of $7.0 million;
    and




·
            the
      sale to the Treasury Department under the TARP Capital Purchase Program of
      Bancorp's Series B Preferred Stock and Common Stock Warrants for gross
      proceeds of approximately $23.4
million.




Bancorp
intends to use the proceeds to fund new loan originations, expand relationship
banking, provide additional capital for regulatory purposes and other general
corporate purposes.





The
recently enacted Emergency Economic Stabilization Act of 2008 (“EESA”) also
increased FDIC deposit insurance on most accounts from $100,000 to
$250,000.  This increase is in place until the end of 2009 and is not
covered by deposit insurance premiums paid by the banking
industry.  In addition, the FDIC has implemented two temporary
programs to provide deposit insurance for the full amount of most non-interest
bearing transaction accounts through the end of 2009 and to guarantee certain
unsecured debt of financial institutions and their holding companies through
June 2012.  We expect to participate only in the program that provides
unlimited deposit insurance coverage through December 31, 2009 for
noninterest-bearing transaction accounts (typically business checking accounts)
and certain funds swept into noninterest-bearing savings accounts. Under that
program, we will pay a 10 basis points fee (annualized) on the balance of each
covered account in excess of $250,000, while the extra deposit insurance is in
place.   At December 31, 2008, we had $106 million in such
accounts in excess of $250,000.





If the
volatility in the market and the economy continue or worsen, our business,
financial condition, results of operations, access to funds and the price of our
stock could be materially and adversely impacted.





Critical Accounting
Policies





Bancorp’s
significant accounting policies and recent accounting pronouncements are set
forth in Note 1 of the consolidated financial statements for the year ended
December 31, 2008 which are set forth on pages F-1 through F-34.  Of
these significant accounting policies, Bancorp considers the policies regarding
the allowance for loan losses and valuation of foreclosed real estate to be its
most critical accounting policies, given the uncertainty in evaluating the level
of the allowance required to cover credit losses inherent in the loan portfolio
and the material effect that such judgments can have on the results of
operations.  In addition, changes in economic conditions can have a
significant impact on real estate values of underlying collateral affecting the
allowance for loan losses and therefore the provision for loan losses and
results of operations as well as the valuation of foreclosed real
estate.  Bancorp has developed policies and procedures for assessing
the adequacy of the allowance for loan losses, recognizing that this process
requires a number of assumptions and estimates with respect to its loan
portfolio.  Bancorp’s assessments may be impacted in future periods by
changes in economic conditions, the impact of regulatory examinations, and the
discovery of information with respect to borrowers that is not known to
management at the time of the issuance of the consolidated financial
statements.











45








Financial
Condition





Total assets increased by
$25,417,000, or 2.6%, at December 31, 2008 to $987,651,000, compared
to $962,234,000 at December 31, 2007.  The following discusses the
material changes between the December 31, 2008 and 2007 balance
sheets.





Cash





Cash and cash equivalents increased
by $21,039,000, or 186.7% at December 31, 2008 to $32,305,000, compared to
$11,266,000 at December 31, 2007.  This increase was primarily due to
the proceeds received in late 2008 from the sale of Series A and Series B
Preferred Stock.





Loans





Loans Held For
Sale.Loans held for sale decreased by $648,000, or 58.9%
at December 31, 2008 to $453,000, compared to $1,101,000 at December 31,
2007.  This decrease was primarily due to a slowdown in loans sold on
the secondary market, and the timing of loans pending sale at
year-end.





Loans
Receivable.Total net portfolio loans receivable increased by
$4,093,000, or 0.5% at December 31, 2008, to $896,006,000, compared to
$891,913,000 at December 31, 2007.  The increase in the loan portfolio
resulted from Bancorp’s ability to attract and retain loan customers in spite of
a downturn in the real estate market.  This increase was the result of
Bancorp’s focus on community lending and increased marketing
efforts.  The increase in the loan portfolio was primarily due to an
increase in residential loan demand, refinancing of existing mortgages and an
increase in funding of commercial loan obligations partially offset by a
decrease in construction, land acquisition and development loans.





Premises and
Equipment





Premises and equipment decreased by
$1,022,000, or 3.3% at December 31, 2008 to $30,267,000, compared to $31,289,000
at December 31, 2007.  This decrease was primarily due to the annual
depreciation of the premises and equipment with minimal new fixed assets added
throughout 2008.





Other
assets





Other assets increased by $4,471,000,
or 31.7% at December 31, 2008 to $18,581,000, compared to $14,110,000 at
December 31, 2007.  This increase was primarily due to the increase in
foreclosed real estate in 2008.





Liabilities





Deposits.Total
deposits increased by $31,093,000, or 4.8% at December 31, 2008 to $683,866,000,
compared to $652,773,000 at December 31, 2007.  This increase was
primarily attributable to Bancorp’s expanded deposit products and its desire to
maintain its competitive edge in the community.  This resulted in
growth in certificates of deposit and savings accounts partially offset by a
decrease in money market accounts.  The net increase in deposits was
primarily used to fund loan growth and repay FHLB-Atlanta advances.





FHLB-Atlanta
Advances.FHLB-Atlanta advances decreased $37,000,000, or
19.5% at December 31, 2008 to $153,000,000, compared to $190,000,000 at December
31, 2007.  This decrease was the result of management’s decision to
repay advances from funds received from increased deposits, as well as proceeds
from issuance of subordinated debentures and preferred stock.





Junior Subordinated Debt Securities
Due 2035.  As of December 31, 2008, Bancorp had outstanding
$20.6 million principal amount of Junior Subordinated Debt Securities Due 2035
(the “2035 Debentures”).  The 2035 Debentures were issued pursuant to
an Indenture dated as of December 17, 2004 (the “2035 Indenture”) between
Bancorp and Wells Fargo Bank, National Association as Trustee.  The
2035 Debentures pay interest quarterly at a floating rate of interest of LIBOR
(4.82% December 31, 2008) plus 200 basis points, and mature on January 7,
2035.  Payments of principal, interest, premium and other amounts
under the 2035 Debentures are subordinated and junior in right of payment to the
prior payment in full of all senior indebtedness of Bancorp, as defined in the
2035 Indenture.  The 2035 Debentures are first redeemable, in whole or
in part, by Bancorp on January 7, 2010.






46





The 2035 Debentures were issued and
sold to Severn Capital Trust I (the “Trust”), of which 100% of the common equity
is owned by Bancorp.  The Trust was formed for the purpose of issuing
corporation-obligated mandatorily redeemable Capital Securities (“Capital
Securities”) to third-party investors and using the proceeds from the sale of
such Capital Securities to purchase the 2035 Debentures.  The 2035
Debentures held by the Trust are the sole assets of the
Trust.  Distributions on the Capital Securities issued by the Trust
are payable quarterly at a rate per annum equal to the interest rate being
earned by the Trust on the 2035 Debentures.  The Capital Securities
are subject to mandatory redemption, in whole or in part, upon repayment of the
2035 Debentures.  Bancorp has entered into an agreement which, taken
collectively, fully and unconditionally guarantees the Capital Securities
subject to the terms of the guarantee.





Subordinated
Notes and Series A Preferred Stock.On November
15, 2008, Bancorp completed a private placement offering consisting of a total
of 70 units, at an offering price of $100,000 per unit, for gross proceeds of
$7,000,000. Each unit consists of 6,250 shares of Bancorp's Series A 8.0%
Non-Cumulative Convertible Preferred Stock and Bancorp's Subordinated Note in
the original principal amount of $50,000. The Subordinated Notes earn interest
at an annual rate of 8.0%, payable quarterly in arrears on the last day of
March, June, September and December commencing December 31, 2008.  The
Subordinated Notes are redeemable in whole or in part at the option of Bancorp
at any time beginning on December 31, 2009 until maturity, which is December 31,
2018.





Troubled
Asset Relief Program.On November 21, 2008, Bancorp closed on
an agreement with the United States Department of the Treasury (“Treasury”),
pursuant to which Bancorp issued and sold (i) 23,393 shares of its Series B
Fixed Rate Cumulative Perpetual Preferred Stock, par value $0.01 per share and
liquidation preference $1,000 per share, (the “Series B Preferred Stock”) and
(ii) a warrant (the “Warrant”) to purchase 556,976 shares of Bancorp’s common
stock, par value $0.01 per share, for an aggregate purchase price of
$23,393,000.





The Series B Preferred Stock
qualifies as Tier 1 capital and will pay cumulative compounding dividends at a
rate of 5% per annum for the first five years, and 9% per annum thereafter. The
Series B Preferred Stock may be redeemed by Bancorp after three years. Prior to
the end of three years, the Series B Preferred Stock may not be redeemed by
Bancorp except with proceeds from one or more Qualified Equity Offerings, as
defined in the Purchase Agreement.





The Series B Preferred Stock has no
maturity date and ranks pari passu with Bancorp’s existing Series A Preferred
Stock, in terms of dividend payments and distributions upon liquidation,
dissolution and winding up of Bancorp.





The Series B Preferred Stock is
non-voting, other than class voting rights on certain matters that could
adversely affect the Series B Preferred Stock. If dividends on the Series B
Preferred Stock have not been paid for an aggregate of six quarterly dividend
periods or more, whether consecutive or not, Bancorp’s authorized number of
directors will be automatically increased by two and the holders of the Series B
Preferred Stock, voting together with holders of any then outstanding voting
parity stock, will have the right to elect those directors at Bancorp’s next
annual meeting of stockholders or at a special meeting of stockholders called
for that purpose. These preferred share directors will be elected annually and
serve until all accrued and unpaid dividends on the Series B Preferred Stock
have been paid.





The Warrant has a 10-year term and is
immediately exercisable at an exercise price of $6.30 per share of Common
Stock.   The exercise price and number of shares subject to the
Warrant are both subject to anti-dilution adjustments.   If
Bancorp receives aggregate gross cash proceeds of not less than $23,393,000 from
Qualified Equity Offerings on or prior to December 31, 2009, the number of
shares of Common Stock issuable pursuant to Treasury’s exercise of the Warrant
will be reduced by one half of the original number of shares, taking into
account all adjustments, underlying the Warrant. Pursuant to the Purchase
Agreement, Treasury has agreed not to exercise voting power with respect to any
shares of Common Stock issued upon exercise of the Warrant.






47





Off-Balance Sheet
Arrangements.  Bancorp has certain outstanding commitments and
obligations that could impact Bancorp’s financial condition, liquidity, revenues
or expenses.  These commitments and obligations include standby
letters of credit, home equity lines of credit, loan commitments, lines of
credit, and loans sold and serviced with limited repurchase
provisions.





Standby letters of credit, which are
obligations of Bancorp to guarantee performance of borrowers to governmental
entities, increased $3,653,000, or 38.3% as of December 31, 2008 to $13,183,000,
compared to $9,530,000 as of December 31, 2007. In 2008, Bancorp experienced an
increase in demand from its borrowers for letter of credit
requirements.





Unadvanced construction loans
decreased $20,298,000, or 25.9% as of December 31, 2008 to $57,940,000, compared
to $78,238,000 as of December 31, 2007. This decrease was primarily the result
of increased funding of existing construction loan obligations in addition to a
decrease in new construction loan originations.





Home equity lines of credit increased
$404,000, or 1.8%, as of December 31, 2008 to $23,299,000, compared to
$22,895,000 as of December 31, 2007.  Home equity lines of credit
allow the borrowers to draw funds up to a specified loan amount, from time to
time.  Bancorp’s management believes it has sufficient liquidity
resources to have the funding available as these borrowers draw on these
loans.





Loan commitments increased
$6,178,000, or 346.3%, as of December 31, 2008 to $7,962,000, compared to
$1,784,000 as of December 31, 2007. This increase was a result of the timing of
loan commitments booked at year end.  Loan commitments are obligations
of Bancorp to provide loans, and such commitments are made in the usual course
of business.





Lines of credit, which are
obligations of Bancorp to fund loans made to certain borrowers, increased
$2,176,000, or 6.1%, to $38,016,000 as of December 31, 2008, compared to
$35,840,000 as of December 31, 2007.  The increase was a result of
stronger demand for this type of loan product during 2008.  Bancorp’s
management believes it has sufficient liquidity resources to have the funding
available as these borrowers draw on these loans.





Loans sold and serviced with limited
repurchase provisions decreased $3,582,000, or 88.4%, as of December 31, 2008 to
$472,000, compared to $4,054,000 as of December 31, 2007.  This
decrease was the result of the slowdown in the market for loans sold on the
secondary market.





Bancorp uses the same credit policies
in making commitments and conditional obligations as it does for its on-balance
sheet instruments.





Comparison of Results of
Operations for the Years Ended December 31, 2008 and 2007.





General.Bancorp’s
net income for the year ended December 31, 2008 was $4,113,000, or $0.39 per
share diluted.  This is compared to $11,111,000, or $1.10 per share
diluted in 2007.  This decrease of $6,998,000, or 63.0%, was primarily
the result of Bancorp experiencing similar challenges faced by many financial
institutions caused by the slowdown in the overall economy, including increased
loan delinquencies and a compression of its interest rate margin, as well as
increased foreclosure related costs.





Net Interest
Income.Net interest income (interest earned net of interest
charges) decreased $4,669,000, or 13.9%, to $28,969,000 for the year ended
December 31, 2008, compared to $33,638,000 for the year ended December 31,
2007.  This decrease was primarily due to a decrease in Bancorp’s
interest rate spread partially offset by an increase in its loan
portfolio.  Bancorp’s interest rate spread decreased by 0.64% to 2.81%
for the year ended December 31, 2008, compared to 3.45% for the year ended
December 31, 2007.  This decrease was the result of interest rates
earned on Bancorp’s loan portfolio decreasing faster than the decrease in
interest rates paid on Bancorp’s interest bearing liabilities. In addition,
Bancorp’s non-accrual loans increased from $7,700,000 at December 31, 2007 to
$54,795,000 at December 31, 2008.  Bancorp discontinues the accrual of
interest on all non-accrual loans, at which time all previously accrued but
uncollected interest is deducted from income.  This resulted in
$2,385,000 of interest income not recorded on these loans.  Bancorp is
uncertain whether it will be able to reduce the interest rate paid on its
interest bearing liabilities by attracting lower cost deposits, due to the
general expectation of continued increased competition for deposit
accounts.






48





Provision for Loan
Losses.TheBank’s loan portfolio is
subject to varying degrees of credit risk and an allowance for loan losses is
maintained to absorb losses inherent in its loan portfolio.  Credit
risk includes, but is not limited to, the potential for borrower default and the
failure of collateral to be worth what the Bank determined it was worth at the
time of the granting of the loan.  The Bank monitors its loan
portfolio at least as often as quarterly and its loan delinquencies at least as
often as monthly.  All loans that are delinquent and all loans within
the various categories of the Bank’s portfolio as a group are
evaluated.  The Bank’s Board, with the advice and recommendation of
the Bank’s delinquency committee, estimates an allowance to be set aside for
loan losses.  Included in determining the calculation are such factors
as the current market value of the loan’s underlying collateral, inherent risk
contained within the portfolio after considering the state of the general
economy, economic trends, consideration of particular risks inherent in
different kinds of lending and consideration of known information that may
affect loan collectibility.  An increase in the loan loss provision
from the beginning of the year to the end of a year is the result after an
analysis of the aforementioned factors and applying that rationale to the total
portfolio.





The total allowance for loan losses
increased $4,032,000, or 37.4% to $14,813,000 as of December 31, 2008, compared
to $10,781,000 as of December 31, 2007.  The increase was a result of
the current year’s addition to the allowance partially offset by charge offs
incurred.   During the year ended December 31, 2008, the
provision for loan losses was $7,481,000 compared to $2,462,000 for the year
ended December 31, 2007.  This increase of $5,091,000 or 206.8% was a
result of an increase in loan delinquencies, an increase in the loan portfolio,
and management’s determination that adding to the provision for loan losses was
appropriate for the level of inherent risk in its portfolio as compared to the
year ended December 31, 2007.





Bancorp continues to experience
challenges similarly faced by many financial institutions resulting from the
slowdown in the economy and real estate markets, including increased loan
delinquencies. Continued declines in real estate values, home sales volumes and
financial stress on borrowers as a result of the uncertain economic environment,
including job losses and other factors, have adversely affected Bancorp’s
borrowers. This economic deterioration has caused loan delinquencies and
impaired loans to increase.  Bancorp expects loan delinquencies and
impaired loans to continue to increase in 2009.





Other Income and Non Interest
Expenses.Revenues from mortgage banking activities decreased
$236,000, or 41.0% to $339,000 for the year ended December 31, 2008, compared to
$575,000 for the year ended December 31, 2007.  This net decrease was
primarily the result of a $71,000 increase in gain on sale of loans, offset by a
decrease in mortgage processing and servicing fees of $307,000 for the year
ended December 31, 2008 compared to the year ended December 31,
2007.  This decrease was attributable to a general slowdown in loan
activity, which resulted in fewer loans sold on the secondary market, but at
higher gains during 2008 and less mortgage processing and servicing released
fees during 2008.





Real estate commissions decreased
$1,416,000, or 57.8% to $1,035,000 for the year ended December 31, 2008,
compared to $2,451,000 for the year ended December 31, 2007.  This
decrease was primarily the result of commissions earned on large settlements
that took place during 2007.  Real estate management fees increased
$11,000, or 1.7% to $664,000 for the year ended December 31, 2008, compared to
$653,000 for the year ended December 31, 2007.  This increase was
primarily due to increased fees charged in 2008.





Other non-interest income increased
$96,000, or 14.6% to $753,000 for the year ended December 31, 2008, compared to
$657,000 for the year ended December 31, 2007. This increase was primarily
due to higher letters of credit fees.





Compensation and related expenses
decreased $1,953,000, or 17.6% to $9,117,000 for the year ended December 31,
2008, compared to $11,070,000 for the year ended December 31,
2007.  This decrease was primarily the result of lower commissions
paid on lower loan originations and lower health care costs paid by Bancorp and
employee attrition, partially offset by salary rate increases.  As of
December 31, 2008, Bancorp had 106 full-time equivalent employees compared to
118 at December 31, 2007.





Occupancy decreased $56,000, or 3.3%
to $1,640,000 for the year ended December 31, 2008, compared to $1,696,000 for
the year ended December 31, 2007.  This decrease was primarily due to
lower maintenance costs incurred at Bancorp’s headquarters.







49




Foreclosed
real estate expenses, net increased $661,000, or 286.1% to $892,000 for the year
ended December 31, 2008, compared to $231,000 for the year ended December 31,
2007.  This increase was primarily due to an increase in foreclosed
real estate, write downs taken on foreclosed property and expenses associated
with the property.





Legal fees increased $378,000, or
110.9% to $719,000 for the year ended December 31, 2008, compared to $341,000
for the year ended December 31, 2007.  This increase was primarily due
to an increase in fees associated with loan foreclosures and
collections.





Other non-interest expense increased
$1,771,000, or 56.2% to $4,925,000 for the year ended December 31, 2008,
compared to $3,154,000 for the year ended December 31, 2007.  This
increase was primarily the result of a $260,000 charge relating to an external
wire fraud scheme that occurred in 2008, a $323,000 increase in credit report
and appraisal fees and a $434,000 increase in assessment to the DIF for the year
ended December 31, 2008, compared to the year ended December 31,
2007.





Income
Taxes.  Income taxes decreased $5,036,000, or 63.7% to
$2,873,000 for the year ended December 31, 2008, compared to $7,909,000 for the
year ended December 31, 2007 due to lower pretax income.  The
effective tax rate for the years ended December 31, 2008 and 2007 was 41.1% and
41.6%, respectively.





Comparison
of Operating Results for the Years Ended December 31, 2007 and 2006





General.Bancorp’s
net income for the year ended December 31, 2007 was $11,111,000, or $1.10 per
share diluted.  This compared to $15,748,000, or $1.56 per share
diluted in 2006.  This decrease of $4,637,000, or 29.4%, was
primarily the result of Bancorp experiencing challenges caused by the slowdown
in the real estate market, including increased loan delinquencies and a
compression of its interest rate margin, as well as increased occupancy
costs.





Net Interest
Income.Net interest income (interest earned net of interest
charges) decreased $4,477,000, or 11.7%, to $33,638,000 for the year ended
December 31, 2007, compared to $38,115,000 for the year ended December 31,
2006.  This decrease was primarily due to a decrease in Bancorp’s
interest rate spread partially offset by an increase in its loan
portfolio.  Bancorp’s interest rate spread decreased by 0.74% to 3.46%
for the year ended December 31, 2007, compared to 4.20% for the year ended
December 31, 2006.  This decrease was the result of a decrease in
interest rates earned on its loans, while the interest rates paid on its
interest bearing liabilities increased.





Provision for Loan
Losses.                                                          The
total allowance for loan losses increased $1,755,000, or 19.4% to $10,781,000 as
of December 31, 2007, compared to $9,026,000 as of December 31,
2006.  This increase was a result of the additions in 2007 to the
allowance partially offset by charge offs incurred.   During the
year ended December 31, 2007, the provision for loan losses was $2,462,000
compared to $1,561,000 for the year ended December 31, 2006.  This
increase of $901,000 or 57.7% was a result of an increase in loan delinquencies,
an increase in the loan portfolio, and management’s determination that adding to
the provision for loan losses was appropriate for the level of inherent risk in
its portfolio as compared to the year ended December 31, 2006.





Other Income and Non Interest
Expenses.Revenues from mortgage banking activities decreased
$242,000, or 29.6% to $575,000 for the year ended December 31, 2007, compared to
$817,000 for the year ended December 31, 2006.  This decrease was
primarily the result of a $180,000 decrease in gain on sale of loans, and a
decrease in mortgage processing and servicing fees of $55,000 for the year ended
December 31, 2007 compared to the year ended December 31, 2006.  These
decreases were attributable to a general slowdown in loan activity, which
resulted in fewer loans sold on the secondary market during 2007 and less
mortgage processing and servicing fees during 2007.





Real estate commissions increased
$433,000, or 21.5% to $2,451,000 for the year ended December 31, 2007, compared
to $2,018,000 for the year ended December 31, 2006.  This increase was
primarily the result of commissions earned on large settlements that took place
during 2007.  Real estate management fees increased $75,000, or 13.0%
to $653,000 for the year ended December 31, 2007, compared to $578,000 for the
year ended December 31, 2006. This increase was primarily due to additional
properties being managed in 2007.






50







Other non-interest income increased
$203,000, or 44.7% to $657,000 for the year ended December 31, 2007, compared to
$454,000 for the year ended December 31, 2006. This increase was primarily
a result of a one-time gain of $105,000 realized on a sale of an investment by
Crownsville, and miscellaneous fees collected by the Bank.





Compensation and related expenses
increased $736,000, or 7.1% to $11,070,000 for the year ended December 31, 2007,
compared to $10,334,000 for the year ended December 31, 2006.  This
increase was primarily the result of higher health care costs paid by Bancorp,
and salary rate increases.  As of December 31, 2007, Bancorp had 118
full-time equivalent employees compared to 121 at December 31,
2006.





Occupancy increased $990,000, or
140.2% to $1,696,000 for the year ended December 31, 2007, compared to $706,000
for the year ended December 31, 2006.  This increase was primarily due
to increased depreciation incurred on the new headquarters by HS.





Foreclosed real estate expenses, net
for the year ended December 31, 2007 were $231,000, compared to $0 for the year
ended December 31, 2006.  This increase was due to expenses associated
with loan foreclosures in 2007.





Legal fees increased $200,000, or
141.8% to $341,000 for the year ended December 31, 2007, compared to $141,000
for the year ended December 31, 2006.  This increase was primarily due
to an increase in fees associated with loan foreclosures and
collections.





Other non-interest expense increased
$270,000, or 9.4% to $3,154,000 for the year ended December 31, 2007, compared
to $2,884,000 for the year ended December 31, 2006.  This increase was
primarily the result of a  $173,000 increase in advertising relating
to new product promotions and a $101,000 increase in professional fees relating
to new policy development for the year ended December 31, 2007, compared to the
year ended December 31, 2006.





Income
Taxes.  Income taxes decreased $2,699,000, or 25.4% to
$7,909,000 for the year ended December 31, 2007, compared to $10,608,000 for the
year ended December 31, 2006 due to lower pretax income.  The
effective tax rate for the years ended December 31, 2007 and 2006 was 41.6% and
40.2%, respectively.





Liquidity
and Capital Resources.





In 2008, Bancorp’s sources of
liquidity were loan repayments, maturing investments, deposits, borrowed funds,
sale of equity, and the sale of loans.  Bancorp considers core
deposits stable funding sources and includes all deposits, except time deposits
of $100,000 or more.  At December 31, 2008, core deposits equaled 66%
of total deposits.  The Bank’s experience has been that a substantial
portion of certificates of deposit renew at time of maturity and remain on
deposit with the Bank.  Additionally, loan payments, maturities,
deposit growth and earnings contributed to Bancorp’s flow of funds.





In addition to its ability to
generate deposits, Bancorp has external sources of funds, which may be drawn
upon when desired.  The primary source of external liquidity is an
available line of credit equal to 30% of the Bank’s assets with
FHLB-Atlanta.  The available line of credit with FHLB-Atlanta was
$303,971,000 at December 31, 2008, of which $153,000,000 was outstanding at that
time.  Short-term borrowings were $0 and long-term advances were
$153,000,000, at December 31, 2008.





The
maturities of these long-term advances at December 31, 2008 were as follows
(dollars in thousands):





Rate
                            
                            Amount
                            
                            Maturity2.940%
      to 4.996%
                            
                            $  28,000
                            
                            20095.000%
                            
                            10,000
                            
                            2010-%
                            
                            -
                            
                            2011-%
                            
                            -
                            
                            2012-%
                            
                            -
                            
                            20131.693%
      to 4.340%
                            
                            115,000
                            
                            Thereafter$153,000









51




As of December 31,
2008, Bancorp had outstanding an aggregate of $24,119,000 principal amount of
subordinated debt, consisting of the 2035 Debentures and the Subordinated
Notes.  The 2035 Debentures total $20,619,000, pay interest quarterly
at a floating rate of interest of LIBOR (4.82% December 31, 2008) plus 200 basis
points, and mature on January 7, 2035.  The Subordinated Notes total
$3,500,000 and pay interest at an annual rate of 8.0%, payable quarterly in
arrears on the last day of March, June, September and December commencing
December 31, 2008.  The Subordinated Notes are redeemable in whole or
in part at the option of Bancorp at any time beginning on December 31, 2009
until maturity, which is December 31, 2018.  As of December 31, 2008,
Bancorp had $7,962,000 outstanding in loan commitments, which Bancorp expects to
fund from the sources of liquidity described above.  This amount does
not include undisbursed lines of credit, home equity lines of credit and standby
letters of credit, in the aggregate amount of $74,498,000 at December 31, 2008,
which Bancorp anticipates it will be able to fund, if required, from these
liquidity sources in the regular course of business.





In addition to the foregoing, the
payment of dividends is a use of cash, but is not expected to have a material
effect on liquidity.  As of December 31, 2008, Bancorp had no material
commitments for capital expenditures.





The Bank is subject to various
regulatory capital requirements administered by the federal banking agencies.
Failure to meet minimum capital requirements can initiate certain mandatory, and
possible additional discretionary, actions by the regulators that, if
undertaken, could have a direct material effect on the Bank’s financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank’s assets, liabilities,
and certain off-balance sheet items as calculated under regulatory accounting
practices. The Bank’s capital amounts and classifications are also subject to
qualitative judgments by the regulators about components, risk weightings, and
other factors.Management
believes, as of December 31, 2008, that the Bank meets all capital adequacy
requirements to which it is subject.


We
anticipate that our primary sources of liquidity in fiscal 2009 will be from
loan repayments, maturing investments, deposits, borrowed funds, and the sale of
loans. We believe that these sources of liquidity will be enough for Bancorp to
meet its liquidity needs over the next twelve months.  Cash generated
from these liquidity sources may be affected by a number of factors. See “Risk
Factors” for a discussion of the factors that can negatively impact the amount
of cash we could receive.





Contractual
Obligations





The following table contains, for the
periods indicated, information regarding the financial obligations owing by
Bancorp under contractual obligations.





Payments
      due by period
                    (dollars
      in thousands)Less
      than
                  
                  
                  
                  
                  
                  
                  
                  
                  More
      thanTotal
                  
                  
                  1 year
                  
                  
                  1 to 3 years
                  
                  
                  3 to 5 years
                  
                  
                  5 yearsLong
      term debt
                  
                  $
                  153,000
                  
                  
                  $
                  28,000
                  
                  
                  $
                  10,000
                  
                  
                  $
                  -
                  
                  
                  $
                  115,000Subordinated
      debentures
                  
                  
                  24,119
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  24,119Operating
      lease obligations
                  
                  
                  131
                  
                  
                  
                  94
                  
                  
                  
                  37
                  
                  
                  
                  -
                  
                  
                  
                  -Certificates
      of Deposit
                  
                  
                  554,747
                  
                  
                  
                  441,274
                  
                  
                  
                  83,056
                  
                  
                  
                  30,417
                  
                  
                  
                  -Total
                  
                  $
                  731,997
                  
                  
                  $
                  469,368
                  
                  
                  $
                  93,093
                  
                  
                  $
                  30,417
                  
                  
                  $
                  139,119














52








Item 7A. Quantitative and
Qualitative Disclosures About Market Risk





Qualitative Information About Market
Risk.The principal objective of Bancorp’s interest rate risk
management is to evaluate the interest rate risk included in balance sheet
accounts, determine the level of risks appropriate given Bancorp’s business
strategy, operating environment, capital and liquidity requirements and
performance objectives, and manage the risk consistent with Bancorp’s interest
rate risk management policy.  Through this management, Bancorp seeks
to reduce the vulnerability of its operations to changes in interest
rates.  The Board of Directors of Bancorp is responsible for reviewing
assets/liability policies and interest rate risk position.  The Board
of Directors reviews the interest rate risk position on a quarterly basis and,
in connection with this review, evaluates Bancorp’s business activities and
strategies, the effect of those strategies on Bancorp’s net interest margin and
the effect that changes in interest rates will have on Bancorp’s loan
portfolio.  While continuous movement of interest rates is certain,
the extent and timing of these movements is not always
predictable.  Any movement in interest rates has an effect on
Bancorp’s profitability.  Bancorp faces the risk that rising interest
rates could cause the cost ofinterest bearing
liabilities, such as deposits and borrowings, to rise faster than the yield on
interest earning assets, such as loans and investments.  Bancorp’s
interest rate spread and interest rate margin may be negatively impacted in a
declining interest rate environment even though Bancorp generally borrows at
short-term interest rates and lends at longer-term interest
rates.  This is because loans and other interest earning assets may be
prepaid and replaced with lower yielding assets before the supporting interest
bearing liabilities reprice downward.  Bancorp’s interest rate margin
may also be negatively impacted in a flat or inverse-yield curve
environment.  Mortgage origination activity tends to increase when
interest rates trend lower and decrease when interest rates rise.





Bancorp’s primary strategy to control
interest rate risk is to sell substantially all long-term fixed-rate loans in
the secondary market.  To further control interest rate risk related
to its loan servicing portfolio, Bancorp originates a substantial amount of
construction loans that typically have terms of one year or less.  The
turnover in construction loan portfolio assists Bancorp in maintaining a
reasonable level of interest rate risk.





Quantitative Information About Market
Risk.The primary market risk facing Bancorp is interest rate
risk.  From an enterprise prospective, Bancorp manages this risk by
striving to balance its loan origination activities with the interest rate
market.  Bancorp attempts to maintain a substantial portion of its
loan portfolio in short-term loans such as construction loans.  This
has proven to be an effective hedge against rapid increases in interest rates as
the construction loan portfolio reprices rapidly.





The matching of maturity or repricing
of interest earning assets and interest bearing liabilities may be analyzed by
examining the extent to which these assets and liabilities are interest rate
sensitive and by monitoring the Bank’s interest rate sensitivity
gap.  An interest earning asset or interest bearing liability is
interest rate sensitive within a specific time period if it will mature or
reprice within that time period.  The difference between rate
sensitive assets and rate sensitive liabilities represents the Bank’s interest
sensitivity gap.





Exposure to interest rate risk is
actively monitored by Bancorp’s management.  Its objective is to
maintain a consistent level of profitability within acceptable risk tolerances
across a broad range of potential interest rate environments.  Bancorp
uses the OTS Net Portfolio Value (“NPV”) model to monitor its exposure to
interest rate risk, which calculates changes in NPV.  The following
table represents Bancorp’s NPV at December 31, 2008.  The NPV was
calculated by the OTS, based upon information provided to the OTS.





INTEREST
RATE SENSITIVITY OF NET PORTFOLIO VALUE (NPV)


Net
      Portfolio Value
                  
                  
                  NPV
      as % of PV of AssetsChange In Rates
                  
                  
                  $ Amount
                  
                  
                  $ Change
                  
                  
                  % Change
                  
                  
                  NPV Ratio
                  
                  
                  Change(dollars
      are in thousands)+300
                  bp
                  
                  
                  123,807
                  
                  
                  
                  (14,085
                  )
                  
                  
                  (10
                  %)
                  
                  
                  12.58
                  %
                  
                  
                  (95
                  bp)+200
                  bp
                  
                  
                  131,939
                  
                  
                  
                  (5,952
                  )
                  
                  
                  (4
                  %)
                  
                  
                  13.23
                  %
                  
                  
                  (31
                  bp)+100
                  bp
                  
                  
                  136,762
                  
                  
                  
                  (1,130
                  )
                  
                  
                  (1
                  %)
                  
                  
                  13.56
                  %
                  
                  
                  2
                  bp+50
                  bp
                  
                  
                  171,124
                  
                  
                  
                  33,232
                  
                  
                  
                  24
                  %
                  
                  
                  16.88
                  %
                  
                  
                  334
                  bp0
                  bp
                  
                  
                  137,892
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  13.53
                  %-50
                  bp
                  
                  
                  178,397
                  
                  
                  
                  40,505
                  
                  
                  
                  29
                  %
                  
                  
                  17.44
                  %
                  
                  
                  390
                  bp-100
                  bp
                  
                  
                  140,961
                  
                  
                  
                  3,069
                  
                  
                  
                  2
                  %
                  
                  
                  13.75
                  %
                  
                  
                  22
                  bp





The above
table suggests that if interest rates rise 100 bps, Bancorp’s interest sensitive
assets would decline in value by $1,130,000.







53




Item 8.  Financial
Statements and Supplementary Data





Financial statements and
supplementary data are included herein at pages F-1 through F-34.





Item 9.  Changes
in and Disagreements with Accountants on Accounting and Financial
Disclosure





None.





Item 9A.  Controls
and Procedures





Under the supervision and with the
participation of Bancorp's management, including its Chief Executive Officer and
Chief Financial Officer, Bancorp has evaluated the effectiveness of its
disclosure controls and procedures (as defined in Securities Exchange Act Rule
13a-15(e)) as of December 31, 2008. Based upon this evaluation, the Chief
Executive Officer and Chief Financial Officer have concluded that, as of the
period covered by this report, Bancorp’s disclosure controls and procedures were
effective in reaching a reasonable level of assurance that (i) information
required to be disclosed by Bancorp in the reports that it files or submits
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in the Securities and Exchange
Commission’s rules and forms and (ii) information required to be disclosed
by  Bancorp in its reports that it files or submits under the
Securities Exchange Act of 1934 is accumulated and communicated to its
management, including its principal executive and principal financial officers,
or persons performing similar functions, as appropriate to allow timely
decisions regarding required disclosure.





Bancorp’s management, with the
participation of its Chief Executive Officer and Chief Financial Officer, also
conducted an evaluation of Bancorp’s internal control over financial reporting,
as defined in Exchange Act Rule 13a-15(f), to determine whether any changes
occurred during the quarter ended December 31, 2008, that have materially
affected, or are reasonably likely to materially affect, Bancorp’s internal
control over financial reporting.  Based on that evaluation, there
were no such changes during the quarter ended December 31, 2008.





A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are
met.  Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs.  Because of the inherent
limitations in all control systems, no evaluation of controls can provide
absolute assurance that all control issues and instances of fraud, if any,
within Bancorp have been detected.  Because of the inherent
limitations in a cost-effective control system, misstatements due to error or
fraud may occur and not be detected.











54







MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING








Severn
Bancorp, Inc. (“Bancorp”) is responsible for the preparation, integrity, and
fair presentation of the consolidated financial statements included in this
annual report.  The consolidated financial statements and notes
included in this annual report have been prepared in conformity with United
States generally accepted accounting principles, and as such, include some
amounts that are based on management’s best estimates and
judgments.





Bancorp’s
management is responsible for establishing and maintaining effective internal
control over financial reporting.  The system of internal control over
financial reporting, as it relates to the financial statements, is evaluated for
effectiveness by management and tested for reliability through a program of
internal audits and management testing and review.  Actions are taken
to correct potential deficiencies as they are identified.  Any system
of internal control, no matter how well designed, has inherent limitations,
including the possibility that a control can be circumvented or overridden and
misstatements due to error or fraud may occur and not be
detected.  Also, because of changes in conditions, internal control
effectiveness may vary over time.  Accordingly, even an effective
system of internal control will provide only reasonable assurance with respect
to financial statement preparation.





Management
assessed the effectiveness of Bancorp’s internal control over financial
reporting as of December 31, 2008.  In making this assessment, it used
the criteria set forth by the Committee of Sponsorship Organizations of the
Treadway Commission (COSO) in Internal Control – Integrated
Framework.  Based
on its assessment, management concluded that as of December 31, 2008, Bancorp’s
internal control over financial reporting is effective and meets the criteria of
the Internal Control–
Integrated
Framework.


















































/s/
      Alan J. Hyatt
                
                /s/
      Thomas G. BevivinoAlan
      J. Hyatt
                
                Thomas
      G. BevivinoPresident
      and Chief Executive Officer
                
                Principal
      Financial Officer




55




Item 9B.  Other
Information





Bancorp does not have any employees.
The executive officers of Bancorp are employees at-will of the Bank. The Board
of Directors of the Bank has a Compensation Committee, which determines the
compensation of the executive officers of Bancorp. Annually, the Compensation
Committee of the Bank’s Board of Directors evaluates profiles of comparable
financial institutions to assure that the compensation to its executive officers
is comparable to its peer group.  Other factors used by the
Compensation Committee in determining compensation for its executive officers
include an assessment of the overall financial condition of the Bank, including
an analysis of the Bank’s asset quality, interest rate risk exposure, capital
position, net income and consistency of earnings. The Bank’s return on average
assets and return on equity is considered and compared to its peer
group.  The complexity of the activities of the executive officers are
considered, and intangible items are considered such as the reputation and
general standing of the Bank within the community and the likelihood of
continuing successful and profitable results.





Based on the considerations set forth
above, at its meeting on November 18, 2008, the Compensation Committee
approved bonuses for the Bank’s executive officers for fiscal year 2008 as
follows: Alan J. Hyatt, $72,000; S. Scott Kirkley, $30,000; and Thomas G.
Bevivino, $40,000.  In addition, the Compensation Committee, at its
meeting on November 18, 2008, approved the annual base salaries of the Bank’s
executive officers for fiscal year 2009 as follows: Alan J. Hyatt, $338,000; S.
Scott Kirkley, $200,000; and Thomas G. Bevivino, $188,000.  Mr.
Kirkley has taken a six-month leave of absence effective February 9, 2009, for
personal reasons.  During his leave of absence, he will receive salary
at an annual rate of $100,000.





PART III





Item
10.  Directors and Executive Officers of the Registrant and Corporate
Governance





Reference is made to the section
captioned “Discussion of Proposals Recommended by the Board - Proposal
1:  Election of Directors” in Bancorp's Proxy Statement relating to
the 2009 Annual Stockholders Meeting (“Proxy Statement”), and the information
contained in item 4.1 of this Form 10-K,  for the information required
by this Item, which is hereby incorporated by reference.





Reference is made to the section
captioned “Stock Ownership” in Bancorp’s Proxy Statement for the information
required by this Item, which is hereby incorporated by reference.





Reference is made to the section
captioned “Section 16(a) Beneficial Ownership Reporting Compliance” in Bancorp’s
Proxy Statement for the information required by this Item, which is hereby
incorporated by reference.





Bancorp has adopted a code of ethics
that applies to its employees, including its chief executive officer, chief
financial officer, and persons performing similar functions and
directors.  A copy of the code of ethics is filed as an exhibit to
Bancorp’s Form 10-K for the year ended December 31, 2003, which was filed with
the Securities and Exchange Commission on March 25, 2004.





Item
11.  Executive Compensation





Reference is made to the section
captioned “Executive and Director Compensation” in Bancorp's Proxy Statement for
the information required by this Item, which is hereby incorporated by
reference.











56








Item 12.  Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters





Reference is made to the section
captioned “Stock Ownership,” and “Executive and Director Compensation” in
Bancorp's Proxy Statement for the information required by this Item, which is
hereby incorporated by reference.  The following table provides
certain information as of December 31, 2008 with respect to Bancorp’s equity
based compensation plans.








Number
      of
                
                
                
                Number
      ofsecurities
      to be
                
                
                
                securitiesissued
      upon
                
                Weighted-average
                
                remaining
      availableexercise
      of
                
                exercise
      price of
                
                for
      future issuanceoutstanding
                
                outstanding
                
                under
      equityoptions,
      warrants
                
                options,
      warrants
                
                compensationPlan
      Category
                
                and
      rights
                
                and
      rights
                
                plansEquity
      compensationplan
      approved bysecurity
      holders
                
                114,950
                
                $15.87
                
                506,050Equity
      compensationplans
      not approved bysecurity
      holders
                
                -
                
                -
                
                -Total
                
                114,950
                
                $15.87
                
                506,050








Item 13.  Certain
Relationships and Related Transactions, and Director
Independence





Reference is made to the sections
captioned “Executive and Director Compensation - Compensation Committee
Interlocks and Insider Participation,” and “Executive and Director Compensation
- Certain Transactions With Related Persons” in Bancorp's Proxy Statement for
the information required by this Item, which is hereby incorporated by
reference.





Reference is made to the section
captioned “Director Independence” in Bancorp’s Proxy Statement for the
information required by this Item, which is hereby incorporated by
reference.





Item
14.  Principal Accounting Fees and Services





Reference is made to the section
captioned “Discussion of Proposals Recommended by the Board – Proposal 2:
Ratification of Appointment of Independent Auditor - Relationship with
Independent Auditor” and “Policy on Audit and Examining Committee Pre-Approval
of Audit and Non-Audit Services of Independent Auditor” in Bancorp's Proxy
Statement for the information required by this Item, which is hereby
incorporated by reference.











57





PART IV





Item
15.  Exhibits, Financial Statement Schedules





(a)                The
following consolidated financial statements of Bancorp and its wholly owned
sub­sidiaries are filed as part of this report:





1.           Financial
Statements


·Report of Beard
Miller Company LLP, independent registered public accounting firm.


·Consolidated
      statements of financial condition at December 31, 2008 and December 31,
      2007


·Consolidated
      statements of income for the years ended December 31, 2008, 2007, and
      2006


·Consolidated
      statements of cash flows for the years ended December 31, 2008, 2007, and
      2006


·Consolidated
      statements of stockholders’ equity for the years ended December 31, 2008,
      2007 and 2006.


·Notes to
consolidated financial statements





2.           Financial Statement
Schedules


All
financial statement schedules have been omitted, as required information is
either inapplicable or included in the consolidated financial statements or
related notes.





3.           Exhibits


The following exhibits are filed as
part of this report:





Exhibit
No.       Description of
Exhibit





3.1            Articles of
Incorporation of Severn Bancorp, Inc., as amended


3.2            Bylaws of
Severn Bancorp, Inc., as amended (1)


4.1                     Warrant
for Purchase of Shares of Common Stock (2)


10.1+                 Description
of Compensation of Directors and Officers


10.2+                 Stock
Option Plan (3)


10.3+                 Employee
Stock Ownership Plan (4)


10.4+                 Form
of Common Stock Option Agreement (5)


10.5+                 2008
Equity Incentive Plan (6)


10.6                   Form
of Subscription Agreement (7)


10.7                   Form
of Subordinated Note (7)


10.8
            Purchase
      Agreement, dated November 21, 2008, between Bancorp and the United States
      Department of the Treasury (2)


14                      Code
of Ethics (8)


21.1                   Subsidiaries
of Severn Bancorp, Inc.(9)


23.1                   Consent
of Independent Registered Public Accounting Firm


31.1                   Certification
of CEO pursuant to Section 302 of Sarbanes-Oxley Act of 2002


31.2                   Certification
of CFO pursuant to Section 302 of Sarbanes-Oxley Act of 2002


32
            Certification of CEO and CFO pursuant to Section 906 of Sarbanes-Oxley Act
      of 2002





+ Denotes
management contract, compensatory plan or arrangement.





(1)Incorporated by reference
from Bancorp’s Annual Report on Form 10-K for fiscal year ended December 31,
2007 and filed with Securities and Exchange Commission on March 12,
2008.





(2)Incorporated
by reference from Bancorp’s Current Report on Form 8-K filed with the Securities
and Exchange Commission on November 24, 2008.







58




(3)Incorporated by reference from
Bancorp's Annual Report on Form 10-K filed for fiscal year ended December 31,
2004 and with the Securities and Exchange Commission on March 21,
2005.





(4)Incorporated by reference
from Bancorp's Registration Statement on Form 10 filed with the Securities and
Exchange Commission on June 7, 2002.





(5)Incorporated by reference
from Bancorp’s Current Report on Form 8-K filed with the Securities and Exchange
Commission on March 20, 2006.





(6)Incorporated by reference from
Bancorp’s 2008 Proxy Statement filed with Securities and Exchange Commission on
March 12, 2008.





(7)  Incorporated
by reference from Bancorp’s Current Report on Form 8-K filed with the Securities
and Exchange Commission on November 18, 2008.





(8)Incorporated by reference from
Bancorp's Annual Report on Form 10-K for fiscal year ended December 31, 2003 and
filed with the Securities and Exchange Commission on March 25,
2004.





(9)Incorporated by reference
from Bancorp’s Annual Report on Form 10-K for fiscal year ended December 31,
2006 and  filed with the Securities and Exchange Commission on March
14, 2007.









59








SIGNATURES





Pursuant to the requirements of
Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.





SEVERN BANCORP, INC.





March 11,
2009                                                           /s/ Alan
J.
Hyatt


Alan J. Hyatt


Chairman of the Board,
President,


Chief Executive Officer and
Director


















60





Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.





March 11,
2009                                                           /s/ Alan J.
Hyatt


Alan J. Hyatt


Chairman of the Board,


President, Chief Executive
Officer


and
Director





March 11,
2009                                                           /s/ Thomas G.
Bevivino


Thomas G. Bevivino, Executive
Vice


President,
Chief Financial Officer,


Secretary
and Treasurer





March 11,
2009                                                            /s/ Melvin E. Meekins,
Jr.


Melvin E.
Meekins, Jr.,


Vice
Chairman of the Board





March 11,
2009                                                           /s/Melvin
Hyatt


Melvin Hyatt, Director





March 11,
2009                                                            /s/ Ronald P.
Pennington


Ronald P.
Pennington, Director





March 11,
2009                                                           /s/ T. Theodore
Schultz


T.
Theodore Schultz, Director





March 11,
2009                                                            /s/ Albert W.
Shields


Albert W.
Shields, Director





March 11,
2009                                                            /s/ Louis DiPasquale,
Jr.


Louis DiPasquale, Jr.,
Director





March 11,
2009                                                          /s/ Keith
Stock


Keith Stock, Director








61